ECB's Lane Draws a Line in the Sand at 1.20 for Euro-Dollar Exchange Rate

- EUR/USD capitulates at 1.20, heads lower
- ECB's Lane confirms ECB uncomfortable with strengthening EUR
- "profit taking in EUR/USD and EUR/GBP" - Soc Gen

Above: ECB Chief Economist Philip Lane. Image copyright ECB

• EUR/USD spot rate at time of publication: 1.1865
• EUR/USD bank transfer rates (indicative guide): 1.1450-1.1533
• FX specialist provider rates (indicative guide): 1.1760
• More information on the above, here

The Euro came under pressure and dropped sharply against a host of its key peers in the mid-week trading session following comments from a European Central Bank committee member that suggested authorities were starting to become uncomfortable with the single currency's recent appreciation.

Recent Euro strength saw the headline Euro-to-Dollar exchange rate on Tuesday touch 1.20 for the first time since May 2018, sparking comments from ECB Chief Economist Philip Lane said that "the euro-dollar rate does matter".

"The ECB’s Lane yesterday said they don’t look at the exchange rate, but the 1.20 level in EUR/USD "matters": that is called looking at the exchange rate, and it looks like the FX fightback may have begun," says Michael Every, Global Strategist at Rabobank.

The comments coincide with the EUR/USD running into the psychologically significant 1.20 barrier which is layered with sell orders and was always going to be a tough nut for Euro bulls to crack.

The capitulation in the EUR/USD has in turn triggered a broader comeback in the U.S. Dollar which has impacted other major currencies, commodities and equity markets.

However the falling Euro-Dollar exchange rate appears to be aiding the Pound's efforts against the Euro, where the GBP/EUR exchange rate is treading water near 12 week highs.

"His remarks yesterday that the currency's value "does matter" added to profit taking in EUR/USD and EUR/GBP," says Kenneth Broux, a strategist at Société Générale.

Since the Euro's launch in 1999 the Euro-Dollar exchange rate has occupied levels above 1.20, therefore in the broader context of the currency's natural historical range the recovery in the single-currency from 2020 lows around 1.08 could be viewed as a return to a natural territory.

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A rising Euro tends to raise the cost of goods and services produced in the Eurozone on the international market, while lowering the euro-denominated profits of Eurozone exporters meaning the rally in the currency's value could be viewed by the ECB as working against the region's economic recovery and is therefore unwelcome.

Direct intervention by a central bank with a specific aim of devaluing a currency is however considered to be manipulation, and the ECB's actions will therefore likely be limited to verbal intervention, particularly as the Trump administration has proven highly sensitive to currency valuations as a tool to undermining U.S. trade competitiveness.

"Whether this marks the first bout of verbal intervention remains to be seen but does serve as a reminder that the issue of EUR strength will be posed at the 10 September ECB press conference," says Francesco Pesole, a strategist at ING Bank.

The ECB's aggressive monetary policy decisions over recent years, that have seen a surge in quantitative easing and deep cuts to the bank's interest rates, have delivered a weaker Euro according to analysts. The Euro's recent rally might therefore hasten any new expansionary policy initiatives that the ECB is planning.

We reported just last week that the Euro's strength would likely soon ping on the ECB's radar as it was approaching 1.20, but we noted Goldman Sachs economists were of the view that the Euro's rally would ultimately avoid the ire of the ECB.

"We find that an exogenous 10% trade-weighted Euro appreciation typically reduces real GDP and consumer prices each by around 1% after two years. This rule of thumb implies that the appreciation so far might lower growth and inflation by about ¼ percentage point in each of the next two years," says Sven Jari Stehn, chief European economist at Goldman Sachs, before noting that such growth headwinds are minuscule compared with the 7.1% rebound anticipated by the bank for next year.

Goldman Sachs expects the Euro to strengthen further from here - to 1.25 against the Dollar - in twelve months and roughly 2.5% on a trade-weighted basis.

"We expect the Euro area economy to outperform other countries and see the Euro as under-owned in international portfolios and under-valued in our fair value models," Stehn says. "EUR appreciation primarily reflects an improvement of the economic outlook and constructive institutional change in the Euro area’s fiscal architecture. The stronger Euro is, therefore, unlikely to be a significant concern for the ECB at this stage."

However, other analysts have said for some time now that the 1.20 threshold as a potential line in the sand for the ECB.

"The ECB is by the way probably not ready to accept >1.20 levels without a battle either. They managed to temporarily temper the EUR/USD momentum in August and September 2017 when sources kept leaking stories to Reuters and Bloomberg every time 1.20 was breached. We are on alert of a similar rhetorical intervention from Frankfurt should the EUR/USD gain too fast again," says Andreas Steno Larsen, chief FX strategist at Nordea Markets.

Whether or not the Euro's move lower at the time of writing is a direct consequence of Lane's comments is of course debatable as the ECB lacks the ability or the political space to directly target a lower Euro exchange rate. Indeed, the comments come at a time when the Euro's rally was already looking overdone on a technical basis and ready to give back some of its gains, thereby providing a neat narrative for the correction.

"1.20 may prove a temporary cap for the EUR. That said, a generally positive set of manufacturing PMIs around the world yesterday is good news for the cyclical EUR and despite extreme long positioning, 1.1850 could prove the limit of the current correction," says Pesole.