Euro Retreats after ECB Blows Hot and Cold On Currency Strength and 'No Deal' Brexit Risk Builds

Image © European Central Bank

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The Euro-to-Dollar exchange rate beat a further retreat from September 01 highs on Friday after the European Central Bank (ECB) blew hot and cold in its views on currency strength and as a beaten and bruised Pound Sterling exacerbated upward pressure on the trade-weighted single currency, while doing little to constrain EUR/USD.

ECB Chief Economist Philip Lane said Friday that he and other policymakers will continue to assess carefully the information incoming from the economy “including developments on the exchange rate” because “the recent appreciation of the euro exchange rate dampens the inflation outlook,” and as a result “the scale of the upward revision in core inflation has been significantly muted by the appreciation of the euro exchange rate.”

Lane’s role at the ECB is thought to be of increased importance not only because there’s a waning pandemic which is leaving behind in its wake, economic destruction of a historic order but also because the newly-inaugurated President of the ECB is not an economist or financial practitioner. Christine Lagarde, former head of the International Monetary Fund, is a lawyer by trade much like Chairman of the Federal Reserve Jerome Powell.

“Philip Lane of the ECB reportedly 'toughened' the central bank's rhetoric aimed at thwarting EUR appreciation. The risk of a moderate policy misstep is growing after Lagarde told reporters yesterday there was no need to 'overreact' to EUR strength,” says Stephen Gallo, European head of FX strategy at BMO Capital Markets. “The more policymakers focus on the currency, the more it will look like the central bank is undermining its own message.”

Lane’s comments came after the ECB effectively shrugged off the double-digit Euro rally that's helped lift the trade-weighted currency nearly six percent.

Above: Euro-to-Dollar rate shown at 15-minute intervals.

The rising Euro threatens to cut import and consumer prices in a Eurozone economy where inflation pressures have long been woefully inadequate.

"Lane may be worried about the impact of EUR weakness on the Eurozone inflation outlook, but the impact on the market from his concerns has been considerably dampened by the perception that unease over the current value of the currency is not shared by the majority of the ECB’s Governing Council," says Jane Foley, a senior FX strategist at Rabobank. "While in the absence of a fresh bearish trigger the single currency EUR/USD is likely to continue finding support on dips below 1.18 in the very near term, we continue to see scope for a correction lower towards EUR/USD1.16 on a 3 month view."

Strengthening currencies can also impair the competitiveness of exports and subsequently undermine the economy although this, as well as the exchange rate, only matter to the ECB to the extent that it prevents attainment of an ever-elusive target to produce inflation of “close to, but below 2%”.

President Lagarde was at pains Thursday to stress that the ECB does not target exchange rates but rather inflation, which is a message that’s been repeated on multiple occasions and by a handful of policymakers in the short number of hours since Thursday’s announcement.

"The reason we are not more bullish on EUR/USD today is: i) equities still looking fragile and ii) it is very rare to see EUR/USD and GBP/USD moving in opposite directions," says Petr Krpata, CFA and chief EMEA strategist for currencies and bonds at ING. "A messy period in EU:UK relations is not good news for Europe and in the short term – and while deadlines and ultimata are being hurled at each other – it may be hard to see EUR/USD to progress much further to the upside. That means EUR/USD may trade in a 1.17-1.19 range until GBP finds a floor."

Above: Euro-to-Dollar rate shown at daily intervals.

François Villeroy, Governor at the Bank of France and an influential voting member on the ECB’s Governing Council of rate setters and policymakers, was the latest to assert that the ECB does not target the exchange rate on Friday morning just hours before Lane’s blog post.

But even if the ECB doesn't target the currency the danger may increasingly be that it's forced to do something that ultimately heads off EUR/USD. If not because a Euro-bullish market continues to bid it higher, then possibly because of the impact that a deteriorating Brexit situation is having on the Pound.

Friday’s price action in EUR/USD, GBP/USD and EUR/GBP might be evidence.

ING’s Krpata says “It is very rare to see EUR/USD and GBP/USD moving in opposite directions,” as the two currency pairs share a positive correlation that is evident when looking at most price chart, but the problem for the ECB was that on Friday the two exchange rates did diverge and possibly in order to facilitate a depreciation in GBP/EUR.

EUR/USD was 0.23% higher at 1.1852 Friday but had retreated from session highs closer to 1.19, while GBP/USD was -0.17% at 1.2786 and EUR/GBP was +0.33% at 0.9261 while making for a Pound-to-Euro rate of 1.0797.

GBP/EUR always closely reflects a combination of price action in EUR/USD and GBP/USD, the two currencies’ main exchange rates, and can fall if GBP/USD falls faster than EUR/USD or if the two diverge and vice versa.

Above: Euro-to-Dollar rate at 15-minute intervals with GBP/USD (blue line, left axis) and EUR/GBP (orange line, left axis)

GBP/EUR was quoted just beneath 1.08 Friday but is widely expected to decline toward parity or one-for-one in the event of a ‘no deal’ Brexit.

The rub for the ECB is that if the market’s aversion to the U.S. Dollar is so entrenched that a GBP/EUR depreciation now has to occur as much through a rising EUR/USD as it does a declining GBP/USD, the upward pressure on Europe’s trade-weighted currency would intensify.  

For all that’s often said about Blighty’s Brexit venture, the country does still remain the Eurozone’s third largest trade partner and accounts for more than 15% of the trade-weighted exchange rate.

But this idea is nothing more than a theoretical possibility and a probably-unlikely as well unsustainable one too, given it would contradict basic laws of economics that make overall depreciation a necessity in the event of a messy Brexit, and for both of the currencies concerned.

The case for a EUR/USD that falls with GBP/USD would be more in keeping with the laws of economics, especially when combined with the ECB’s clearly evident concerns, although given the actions of the Fed this year and consensus bullish view on the Euro a lot depends on if investors are really listening.

“On the one hand, we are nearing the culmination of the first UK/EU negotiations since the 2019 UK election, which provided the government with a powerful democratic mandate. On the other hand, COVID-19 has drastically shifted the UK government's calculus on so many levels. Our preference would be to continue building short GBP exposure vs the EUR, the JPY and the CHF within very tight limits,” BMO's Gallo says. “Our base case remains that a UK/EU deal covering some merchandise trade will get done. But it may only happen after one side leaves the negotiating table, or well after the end of 2020."

Above: Euro-to-Dollar rate shown at weekly intervals alongside Pound-to-Dollar rate (blue line, left axis)..