EUR/USD: ECB to Raise Rates Faster than Market Expects but there's a Catch says Capital Economics

© European Central Bank, reproduced under CC licensing

- ECB to raise rates in 2019, follow up faster than market expects.

- EUR rate to rise as Federal Reserve slows, boosting the EUR/USD. 

- But hikes damage periphery economies, question viability of Euro.  

The EUR/USD rate will be boosted over coming years as the European Central Bank (ECB) raises its interest rate faster than the market currently anticipates, according to Capital Economics, but this normalisation of monetary policy will lead to fresh questions about the currency union's sustainability.

Eurozone growth slowed to an annualised pace of 2.1% during the second-quarter, down from 2.5% at the beginning of the year and 2.7% at the end of 2017. However, and despite President Donald Trump's "trade war" against China and skirmishes with the EU, the extent of any further slowdown over coming quarters will be limited.

"Euro-zone growth looks set to slow only gradually as consumers take up some of the slack from weaker exports. But prospects for the region’s economies have diverged markedly and we see France becoming the star performer while Italy lags far behind," says Jennifer McKeown, chief European economist at Capital Economics, in a note to clients.

McKeown flags that busiuess surveys, including the monthly IHS Markit PMI survey of the Eurozone manufacturing and services sectors, suggest growth will stabilise around 0.4% on a quarterly basis. That would be in line with the rate of expansion seen in the first-quarter but beneath that clocked up throughout 2017.

This kind of performance is expected to see the Eurozone grow by 2% for 2018 and at lesser rates of 1.8% and 1.5% respectively in 2019 and 2020. Although reduced sharply from the levels of expansion seen in 2017, those numbers would still leave the bloc's economy growing faster than its so called potential rate, which the ECB estimates to be around 1.5%.

Above-potential growth should help stoke a recovery of the inflation pressures that the ECB has done so much to encourage over recent years, although McKeown says this will be concentrated largely in the economies which are already outperforming their rivals, such as France and Germany. 

Germany, which is effectively the world's high-tech manufacturer, suffered a sharp decline of industrial production this year. But that decline was driven largely by one-off disruptions to activity in the car industry that disguise an economy that is otherwise in rude health. McKeown says German GDP will grow by 1.8% for 2018 and 2019. 

Meanwhile, efforts by President Emmanuel Macron to reduce joblessness by making it easier for companies to hire and fire staff are also expected to continue baring fruit, with McKeown forecasting the unemployment rate will fall to 8% in 2020. French unemployment fell from 10% in February 2017 to 9.3% in August 2018.  

"Monetary policy is still very accommodative and falling interest rates and stronger lending growth are supporting the domestic economy. ECB rate hikes are unlikely to begin until late in 2019, but the prospect of higher wage growth has led us to revise our forecast further above the consensus in 2020. Since the economy will be operating beyond its capacity, this should not do much damage to growth in the region on average," McKeown says. 

That would be positive for the Euro-to-Dollar rate, particularly if the ECB begins to raise its interest rate just as financial markets are beginning to glimpse an end to the Federal Reserve tightening cycle that has seen U.S. rates rise from 0.25% at the end of 2015 to to 2.25% in September 2018. 

Changes in interest rates are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators. Rising rates tend to lift their respective currencies and vice versa.

The European Central Bank has said it will end the quantitative easing programme that has seen it buying tens of billions worth of European government bonds each month ever since the early days of 2015, in December 2018.

It also told markets that interest rates could rise once "through the summer of 2019" but that this is contingent on the inflation outlook remaining consistent with a return of inflation toward its target of "close to but below 2%". 

The ECB's main refinancing rate, marginal lending rate and deposit rate are currently being held at 0%, 0.25% and -0.4% respectively.

"In all, we have nudged down our forecasts by 0.2ppts in each year, to 2.0% this year, 1.8% next and a still above-potential 1.5% in 2020. This positive outlook is not common to all countries and the highly indebted periphery will suffer from even modest monetary policy tightening. We suspect that renewed economic divergence will cause concerns about the currency union’s sustainability to resurface in time," McKeown warns. 

The rub for the European Central Bank and single currency is that an eventual interest rate rise, which would mark an escape from the crisis era for much of Europe, could be what undermines their own existences over the longer term.

This is because although the German and French economies are motoring along well enough, to the extent where interest rate rises may soon become appropriate, the same cannot be said for countries like Italy, Portugal and Greece. 

The so called periphery countries that were the poster children of the Eurozone debt crisis will suffer when interest rates begin to rise. Not least of all because higher borrowing costs will reduce both household and government spending. 

McKeown and the Capital Economics team are suspicious that this could lead to renewed questions about whether it is even possible to merge such an economically disparate collection of countries together in a currency union. Such soul searching would almost certainly be a significant negative for the Euro-to-Dollar rate. 

The Euro-to-Dollar rate was quoted 0.03% lower at 1.1497 around the London close Thursday and is down 4.14% for 2018.

Advertisement
Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here