Politics and the fundamentals have driven the euro gains

Minutes of ECB meeting show concerns about the strength of the euro

European Central Bank president Mario Draghi: he  may signal when its bond-buying programme will end in Frankfurt in October.  Photograph: David Sleator

European Central Bank president Mario Draghi: he may signal when its bond-buying programme will end in Frankfurt in October. Photograph: David Sleator

 

History tells us two things about currency forecasts: most tend to point in the same direction, and nearly all are wrong. At the start of the year the euro sank to a 13-year low of $1.03, prompting a flurry of negative predictions about the future trajectory of the currency and more speculation about when the European Central Bank would finally turn off the tap on its bond-buying programme, brought in to prop-up the crisis-battered economy.

With Donald Trump promising a major economic dollar-boosting stimulus in the US and fears that the European project could be thrown into further turmoil by the election of far-right candidates in the Netherlands and France, shorting the euro was all the rage.

Bond investor Michael Hasenstab, the man who made an audacious bet on Irish government bonds in the middle of 2011 when the country’s credit rating was downgraded to “junk” status, described it as a “hedge against populism”.

Forecasters – Goldman Sachs, Barclays and Deutsche Bank included – talked of euro/dollar parity as an inevitability. The last time we had parity was in 2002.

In the end the exact opposite happened. The euro steamrolled the dollar, gaining roughly 13 per cent in a matter of months, before hitting a 2½-year high of $1.18 in early August, making it the best-performing G10 currency of 2017.

Fundamentals

The anti-establishment, eurosceptic shift that underpinned the Brexit vote was pushed back by victories for moderate candidates in the Netherlands and France, while Trump’s stimulus plan, like most of his policy initiatives to date, has got bogged down in the chaos that seems to surround his administration.

Of course, it wasn’t just politics driving the euro gains. The fundamentals were strong too. Economic and employment growth across the bloc, which had been patchy to that point, were better than pundits had predicted, particularly in peripheral countries like Italy and Spain.

For the European Central Bank, whose only constitutional mandate is to keep the euro zone inflation pegged at close to 2 per cent, the renewed strength of the single currency brings with it a different set of problems. The stronger euro has been anchoring inflation at sub-optimal rates. It’s currently hovering well below the ECB’s target rate at 1.3 per cent.

The main reason for this is the cost of imports, which become relatively cheaper when your currency is stronger. In Europe’s case, this means cheaper oil.

You can see the opposite is currently happening in the UK, where inflation has jumped from an anaemic 0.3 per cent to 2.6 per cent in barely a year on foot of the Brexit-related crash in sterling.

Wages are another driver of inflation, but for reasons nobody seems to have a good handle on they have remained weak despite the upturn in employment across the euro area.

Better yields

The rise in the euro was also helped by a weaker-than-expected dollar despite three rate hikes by the US Federal Reserve since last September.

As any economics undergrad will tell you, rising rates tend to send a currency higher because investors can fetch better yields on their dollar deposits.

However, investors seem to be second-guessing the Fed and its promises of further hikes, speculating the US economy is still not strong enough for a further tightening of monetary policy.

At last month’s ECB meeting Mario Draghi gave a rather anodyne response to a question about the problematic strength of the euro. However, the minutes of the meeting, published on Thursday, suggest he may have underplayed the current level of concern.

The minutes showed rate-setters were very much aware and were in reality anxious about the risk that the euro could threaten the ECB’s efforts to get inflation higher.

The upshot was an immediate tank in the euro, which fell 1 per cent against the dollar to $1.17. Most analysts are now back to predicting a weakening trend for the euro.

All of which feeds into the seemingly endless speculation around when the ECB will finally call time on its stimulus programme, which is still pumping €60 billion into the economy each month.

Clear line of sight

Rumours that Draghi may hint at the likely course of action at the US Fed’s symposium at Jackson Hole next week were scotched by Reuters, with pundits now suggesting he may wait until Frankfurt’s October meeting, giving him a clear line of sight on US policy.

Since the financial crisis, central bankers have extolled the virtue of “forward guidance”, mindful that silence can lead to greater market volatility.

The downside of this has been the virtual scrambling to make sense of Draghi’s remarks, which can be difficult to decipher.

His speech in June was interpreted as indicative of possible tweaks in the bank’s aggressive stimulus policy, and investors moved to price in an announcement as soon as September that quantitative easing (QE) would be reduced.

On foot of this, Germany’s 10-year bond yield had its biggest rise since December 2015, and the euro its biggest jump in a year. At the ECB meeting policy-makers discussed making “incremental” changes to their forward guidance.

For Ireland, so much of the focus in recent times has been on the euro/sterling rate, for obvious reasons. Despite the euro weakening against the pound on Thursday and better-than-expected UK retail numbers, analysts at Morgan Stanley are predicting we’ll see euro/sterling parity by early next year. This would be a doomsday scenario for Irish exporters.

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