Headwinds From the Rising Euro
The rallying Euro has appreciated almost 10% in the last 12 months thanks to reduced political risk, steady growth and the increasing hawkishness of the European Central Bank (ECB).
Some are now saying that the currency is ‘too’ strong and that this could start to have negative effect on growth, with a risk that the ECB might interfere to start talking down the currency.
Analysts at Danske Bank, for example, see the rise in the Euro constraining growth, and as a result, reign in current market expectations that the ECB will start to rapidly put an end its stimulus programme.
“Longer term, the euro appreciation –which we expect will continue – supports our call for a very gradual exit from the ECB. We believe the ECB will continue its QE purchases, but at a reduced pace of EUR40bn per month in H1 18, and that it will announce this at the October meeting with some signalling of it in September,” said Danske’s chief analyst Pernille Bomholdt Henneberg.
The stronger euro, “is a headwind to economic activity,” says Henneberg, “as it hurts price competitiveness thereby reducing exports and raising imports.”
He further notes that, “based on the OECD’s new global model, the 5.8% rise in the effective euro since the start of the year should bring GDP growth down by 0.4pp in 2018 and an accumulated 0.7pp in 2019.”
As a result of the strengthening Euro Danske have lowered their official growth forecasts for the region to 1.5% from 1.6% (consensus 1.7%).
Analysts at Morgan Stanley, meanwhile, think the ECB will probably “tolerate a stronger Euro because the reasons for its rise are ‘good’.”
The so called ‘good’ reasons include a steadily growing economy, falling unemployment, reduced political risk from anti-Euro parties, deep economic reform and the ECB’s own more confident policy stance.
If the reasons had been ‘exogenous’ the ECB might be minded to intervene to weaken the currency – such as for example, if the US Dollar were to continue devaluing at its current pace.
Yet the role of the Dollar is complicated even more by the fact that as it weakens it also tends to raise the price of commodities because they are priced in Dollars, and this is likely to offset the negative effects of a strengthening Euro.
More expensive commodities could import inflation into the Eurozone, offsetting the disinflationary effects of a stronger Euro, and thus leading the ECB to tighten policy more rapidly, further leading to an even stronger Euro...
Euro to Reach 1.28
Overall Morgan Stanley are confident the Euro will continue rising despite interference from the ECB which at best will merely “blunt” the momentum but not end the rise altogether:
“So far, our forecasts have been holding true,” they say in a recent note.
“Growth and other macroeconomic data continue to point to above-trend levels albeit at a slower pace while the performance of populist parties has continued to worsen (e.g., Italy's Five Star in recent municipal elections). Indeed, the 'bull case' previously outlined of EURUSD at 1.28 by 2Q18 is looking increasingly plausible.”
Other supportive factors are also coming into play, such as, for example, the sea-change in how the Euro reacts to market sentiment.
Previously the currency had strengthened as global sentiment had turned negative, like a safe-haven currency, however, now the Euro is exhibiting a more ‘normal’ relationship to risk, with which it rises in tandem.
“This positive correlation of EUR to risk is a significant departure from when the ECB was cutting rates and engaging in QE, where EUR strength was negatively related to risk appetite,” said Morgan Stanley.
A more optimistic outlook for the single currency has led to less hedging of Euro positions which has further reduced the impact of negative sentiment.
Exchange Traded Fund (ETF) data shows a marked increase in inflows and a reduction in hedging of Euro-denominated equity positions.
“EUR now trades in a more ‘traditional’ manner, with better growth prospects and reduced political challenges driving capital inflows and expectations of continued EUR appreciation. This is most clearly evidenced in ETF data, which show both an increase in inflows but also a striking rise in unhedged inflows. Indeed, over 90% of inflows since February have been on an unhedged basis.”
The Euro is trading well below its fair value as the ECB caters towards its weakest link – Italy.
As ECB policy begins to normalize, the Euro will return to fair value at around the 1.30-35 mark, add Morgan Stanley.
Speed of Rise
Concerns that the ECB will start to try to devalue the Euro depend more on the pace rather than the extent of the rise.
If the pace were to continue at the present rate, it might tempt the ECB to “blunt the Euro’s rise”.
The pace is very high compared to historical precedents.
“Measuring monthly changes, the change over July was in the 91st percentile with a Z-score of 1.33, with the quarterly results suggesting a similar magnitude at 1.28 or the 90th percentile,” said Morgan Stanley.
Draghi’s speech at Jackson Hole could offer the ECB President the perfect opportunity to talk down the currency, although given his avowed promise not to discuss the Euro, it seems unlikely.
If Draghi did ever try to address the Euro it would probably be via a subtle, camouflaged ‘trope’.
The ECB president could, for example, use the impact on inflation as a way of discussing the rising Euro.
Alternatively, he could talk about “tightening financial conditions”, or even ‘global factors’ - or indeed via discussion of other currencies becoming undervalued.
“While unlikely, a particularly explicit reference to the USD being "undervalued" should be taken as a very strong signal,”
said Redeker.
Impact on Inflation
A key risk to the Euro is the impact a strengthening currency on inflation.
It would be expected that a strengthening Euro would lower inflation via cheapening foreign imports.
It is this negative impact on inflation which would probably be the msot likely catalyst to ECB intervention.
Current ECB staff projections for inflation are based on a much lower exchange rate level of 1.08-9.
There is a material risk, therefore, that these staff projections will be revised lower when they are released in September, to take into account the impact of the much higher exchange rate.
“Staff forecast that HICP inflation would dip down to 1.3%Y in 2018 before rising back to 1.6%Y in 2019. Embedded in these forecasts is an assumption that EUR stays relatively stable, with EURUSD at 1.08 in 2017 and 1.09 in 2018 and 2019.”
The euro is 9% higher year.-on-year, leading to a likely revision of these estimates.
“ECB staff have estimated that a 1% increase in the NEER (or de facto Euro Index) reduces consumer prices by between 2 and 10bps one year out.”
The change could be between 18 and 90 basis points based on a roughly 9% rise.
“Staff will also incorporate the modest increase in commodity prices and the continued improvement in macro data. If it becomes apparent that the EUR appreciation has dented the expected gradual rising path of core inflation significantly, President Draghi will likely highlight this as a point of concern.”
Despite the headwinds mentioned above, Morgan Stanley expect the Euro to continue rising.
“Despite the risk of the ECB pushing back, ultimately we believe that EUR will continue to rise due to the positive macro and policy environment, with USD weakness adding further to the rally.”
Economists are upbeat about the future and they expect liquidity to remain ‘ample’ and “risk appetite to remain strong”.
Long-term structural support should also come from reserve managers who had slashed their allocations of Euros before because of the Eurozone debt crisis but are now likely to be on a restocking drive.
The highest current account surplus in the history is a further support to the Euro as are signs that Swiss investors are “finally joining the fray”.
To conclude, Morgan Stanely think that although interference from the ECB will probably blunt the Euro’s rise it won’t stop it.
“The ECB will ultimately find it a difficult current against which to swim,”
says Redeker.
“We believe that the ECB recognizes this and will thus try not to halt EUR's rise entirely over time, but will rather simply prefer to blunt it at the margin to foster a more gradual and less volatile glide path higher,” he concludes.