Last week, ECB Chief Economist, Philip Lane, delivered a speech warning that the recent strength of the euro is a concern for the Governing Council. If the currency keeps appreciating, it will weigh on exports, drag down prices and increase pressure on the ECB to provide additional monetary stimulus. It was the first time in recent memory that a member of the ECB has made specific reference to the euro and highlights the [understandable] desire for a weak currency in the current economic environment.
Looking at the chart below (regularly featured on page 5 of this report) its clear why we haven’t seen any form of intervention from the ECB in recent years – the euro has been trading comfortably below fair value since 2014 allowing the European manufacturing industry to benefit from a cheap currency. However, following the recent rally from $1.06 in March to last week’s highs just above $1.20, a significant portion of this advantage has been errored away. If the dollar keeps depreciating (as many analysts predict it might) it is entirely possible that the euro could flip into ‘overvalued’ territory in the months ahead.
CHART: EURUSD Spot vs Fair Value
Citing the Fed’s move towards an average inflation target two weeks ago as a partial catalyst for the dollar’s most recent decline, one Governing Council member said that it increases pressure on the ECB to respond with its own strategy review which it aims to complete next year. However, as we all know, currencies can move surprisingly quickly and by the time the ECB does respond, we could have already seen a significant change.
At this point, is worth noting that the recent strength of the euro against the dollar isn’t just the result of influences from the dollar side. The euro started to appreciate notably in July following the announcement of a €750bn stimulus package in response to the COVID-19 pandemic. The fact that it signaled unification amongst the EU member states meant far more than the package itself (which was replicated by Governments across the globe).
What can we expect going forward?
For now, the prospect of anything more than a few choice words from various ECB policy makers seems remote. In the same way that Donald Trump has repeatedly voiced concerns about the strength of the dollar, its entirely possible that various ECB members will attempt to talk down the euro in the months ahead with the thread of additional stimulus. However, whether there is scope for the Governing Council to follow through and ease monetary policy further (either by cutting rates or increasing the size of its asset purchase programme) is another matter. Under Lagarde’s leadership, there is already a debate about the effectiveness of ultra loose monetary policy and thus we question the appetite for further easing, particularly in the near term.
That said, back August we wrote piece commenting on how currency could become the new battleground on which the next phase of the financial crisis is fought. With global interest rates anchored around zero, central bank’s balance sheets already at record / uncomfortable sizes and Governments facing record current account deficits, currencies could become the new battleground in a fight for global trade.
For now, we don’t expect any significant action, especially given that the rally in EURUSD has stalled at $1.20. Fair value (calculated using various PPP metrics) sits around $1.25 (depending on which measure of inflation is used) and thus the ECB can’t grumble too much. However, going forward, the likelihood is that the dovish rhetoric from the ECB will be ramped up if the euro continues to advance. From our point of view, its another reason not to get too bullish on EURUSD despite recent momentum and justification for our bearish forecast over the next twelve months.
Author: Marc Cogliatti