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Euro in Danger as Strength Now a Pressing Issue for the European Central Bank

- ECB sees Euro strength as greater problem now than in 2017. 

- Recent Euro moves driven by speculation, not fundamentals.

- EUR/USD, EUR/GBP slump to fresh lows, outlook sours. 

© European Central Bank, reproduced under CC licensing

The Euro sank lower against all of its developed world rivals Thursday after the latest set of European Central Bank meeting minutes showed the single currency's recent strength becoming a more pressing issue of concern for Eurozone rate setters. 

Governing Council members flagged the common currency's 2018 rally as a source of concern for the ECB in a much more pronounced fashion than before, citing it as a material risk to their inflation and economic growth forecasts which could ultimately end up threatening the central bank's ambition to wind down its quantitative easing (bond buying) program later this year. 

"It was remarked that recent movements in the euro exchange rate seemed to relate more to relative monetary policy shocks, including communication, and less to improvements in the macroeconomic outlook for the euro area. This suggested that the exchange rate appreciation could be expected to have a more negative impact on inflation," the ECB says. 

Previously, ECB policymakers had turned a mostly-blind eye to a surging Euro, telling markets that it was largely the result of an improved outlook for the Euro area economy and that the associated uplift in growth would counteract the disinflationary effects of a stronger currency.

Now, they say the Euro is rising because of speculation about changes in monetary policy, which means there won't be an accompanying boost to growth that would typically propogate an higher exchange rate. 

Above: Euro-to-Pound exchange rate at hourly intervals. Captures Thursday afternoon slump.

"In addition, even though the effect of the euro’s appreciation on inflation had been limited so far, the pass-through could be stronger if the shocks turned out to be permanent. Overall, there was broad agreement among members that volatility in the exchange rate of the euro continued to be a source of uncertainty, which required monitoring with regard to its possible implications for the medium-term inflation outlook," the ECB says. 

A rising currency reduces inflation by making imported goods cheaper to buy, and therefore works against the ECB's current objective to ensure the consumer price index remains "close to but below 2%".

It has spent the last three years attempting to boost inflation, which fell below 0% in 2015, through extraordinary monetary policies such as quantitative easing and negative interest rates. 

A rising Euro also makes the cost of Eurozone exports more expensive on global markets, threatening lower international demand and slowing economic momentum.

Above: Euro-to-Dollar rate shown at weekly intervals. Captures 2017-18 appreciation.

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Currently, the Eurozone consumer price index sits at 1.4% although the core-consumer price index, which removes volatile energy and food items from the goods basket measured, sits at just 1%. Both measures of inflation have fallen slightly over the last six months and remained static so far in 2018. Meanwhile, the Euro has risen by 15% against the US Dollar over the last 12 months and by 8.9% on a trade weighted basis. 

Consequently, the European Central Bank tweaked some of its inflation forecasts lower at its latest meeting. It now predicts consumer prices will remain at 1.4% for 2018 but dip lower during 2019, before rising again in 2020. The bank forecasts that the core-CPI index will rise to 1.1% this year, to 1.5% in 2018 and to 1.8% in 2020. Meeting these forecasts in the long term, and avoiding inflation outcomes that contradict them in the short term, is critical for the Euro.

The Euro was one of the best performing global currencies in 2017 as markets bet that the ECB would end its quantitative easing programme - officially known as the Asset Purchase Programme - in 2018 and set up the conditions for a series of interest rate rises. All evidence now points to these dates being pushed back, which works against the Euro.

"The account of the ECB’s March meeting suggests that the Bank will continue to tweak its forward guidance in the months ahead, but that asset purchases will go on until the end of this year and rate hikes are a pretty distant prospect," says Jennifer McKeown, a European economist at Capital Economics. 

"We are pushing out the end of net APP from September 2018 until December 2018," says Philippe Gudin at Barclays. "The ECB would then pause for roughly six months and in June 2019 would deliver a DFR hike of +15bp. Then, in Q4 19, we forecast a DFR and a MRO hike of +25bp each, effectively removing negative rates by end of 2019."

The ECB said in December it will continue buying €30 billion of European bonds each month until “September 2018 or beyond”, with the final stoppage subject to developments around inflation. Until December 2017 it had been buying €60 billion or more each month in an effort to stoke consumer price pressures by spurring economic activity.

If Eurozone inflation does not show signs of making a sustainable return toward its 2% target then the ECB will find it increasingly difficult to justify ending the APP programme and an interest rate rise will remain a "distant prospect" for a long time to come.

Despite Thursday's warnings on the exchange rate, the central bank says it remains confident of a further pickup in economic growth and price pressures.

"Members widely shared the assessment provided by Mr Praet in his introduction that the incoming information, including the new staff projections, corroborated the strong and broad-based growth momentum in the euro area economy. This outlook for growth confirmed the increased confidence that inflation would converge to the Governing Council’s inflation aim of below, but close to, 2% over the medium term," the ECB says. 

However, the rub for European Central Bank officials and for the Euro is that, since its meeting in early March, various indicators have begun to point toward a loss of momentum in the Euro area economy.

First and foremost, IHS Markit surveys of the key European manufacturing and services industries flagged a slowdown in activity during March which was, in part, the result of previous exchange rate developments.

Then, the official measure of industrial output for February surprised on the downside this Thursday, posting its second consecutive monthly fall when markets had been looking for an increase. 

Both of the above developments suggest Eurozone economic growth may have slowed in the first quarter of 2018 which, although not be out of sync with recent events in both the US and UK, would mark the continuation of a trend that began in the final quarter of 2017. Fourth quarter 2017 growth was 0.6%, a fraction slower than the 0.7% seen in the third quarter, which led economists to float the idea that momentum behind the Eurozone upturn may now be waning. 

"We have passed the cyclical peak and entered a phase of moderation in the pace of industrial (as well as overall) growth. Survey indicators remain at high levels, but they have been losing some shine recently, primarily as a result of easing momentum in global trade and concerns about US protectionist policies. Our GDP tracker flags downside risks to our 1Q18 GDP forecast of 0.6% qoq, pointing to a more moderate expansion of about 0.4%," says Edoardo Campanella, an economist at UniCredit Bank. 

While still early days, the moderating Eurozone upturn and emerging concerns at the ECB over the strength of the single currency could mean the Euro's days in the sun are almost up. From here, the currency could become increasingly sensitive to data disappointments and central bank rhetoric on the likely disinflationary impact of its past appreciation.

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