How the Euro Could Benefit from ECB and Fed Policy Differences

• ECB set to leave negative interest rate era behind
• QE programmes & assets posing one last challenge
• Solution distinguishes ECB policy but supports EUR

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The Euro to Dollar rate benefited significantly when the European Central Bank indicated this February that a landmark shift in its monetary policy may be in the pipeline and likely differences with the Federal Reserve’s (Fed) policy process could eventually help EUR/USD recover further.

Europe’s single currency had fallen precipitously against its U.S. counterpart since the early days of 2021 but the downtrend was stopped in its tracks this February when profit-taking by the market on bets in favour of the Dollar was followed by signs of a watershed change in the ECB’s policy stance.

This has gotten analysts and economists updating forecasts in anticipation that the ECB could begin to lift its interest rates late in 2022 or some time in the early months of next year, with many suggesting that it could call an end to the era of negative interest rates in Europe.

“The introduction of negative rates in 2014 resulted in large-scale outflows from European fixed income markets and significant Euro underperformance, beyond what could be explained by changes in rate differentials and oil prices. Similarly, exiting negative rates may help stem persistent fixed income outflows and support the currency,” says Zach Pandl, co-head of global foreign exchange strategy at Goldman Sachs.

“We are therefore revising up our year-end EUR/USD forecasts for the next three years to 1.20 (from 1.15), 1.25 (from 1.20), and 1.30 (from 1.25). These forecasts imply a rebound in EUR/USD to “fair value” by end-2024. Over the near term, Euro appreciation may be held back by widening sovereign spreads and the prospect of faster Fed rate hikes,” Pandl and colleagues Michael Cahill wrote in a research briefing last week.

Above: Euro-Dollar rate shown at 4-hour intervals. Click image for closer inspection.

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• High street bank rates (indicative band): 1.0925-1.1000
• Payment specialist rates (indicative band): 1.1223-1.1238
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Before the ECB does lift interest rates, however, it would first have to end both of its quantitative easing programmes and decide what to do about the trillions in Eurozone government bonds hoovered up by them during the pandemic as well as throughout the years since 2015.

This is a key area in which ECB monetary policy normalisation could look different to the processes underway at the Federal Reserve, Bank of England and some other central banks, although such a difference is not necessarily a negative for Euro-Dollar and other European exchange rates.

“There does feel to be growing momentum on the ECB GC for a possible earlier than expected wind-down of APP. We still envisage a rate hike in Q4 and are looking for opportunities to go long EUR into the period ahead,” says Jeremy Stretch, head of FX strategy at CIBC Capital Markets.

All economies, currencies and central banks are different in their own ways but this is especially true of the ECB, which presides over a monetary union between 19 different countries while each of the underlying economies is governed individually from the respective national capitals.

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But within this union there are also vast differences between the constituent economies, some of which could pose a unique and significant challenge to the ECB as it seeks to recalibrate Eurozone monetary policy for an era in which low levels of inflation can no longer be taken for granted.

“There is a point at which credit spreads stop being a rate differential factor and start having implications for solvency. Once that point is crossed we would expect FX investors to trade wider credit spreads as a negative impulse for the EUR. This is why the pace at which the ECB exits QE from March will matter immensely for FX and credit markets,” says Stephen Gallo, European head of FX strategy at BMO Capital Markets.

Most notable among the financial differences is the variation in national debt levels which, if not taken into account by the ECB, could potentially prevent a uniform application or transmission of the bank’s monetary policy to each and all of the bloc’s various economies.

While currencies do normally tend to benefit as central banks signal that interest rates are likely to rise, the danger for the Euro is that as the ECB does this the markets could begin to demand disproportionately high and troublesome levels of interest from some Eurozone governments.

Above: Euro-Dollar rate shown at daily intervals. Click image for closer inspection.

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This is one legacy of the Eurozone debt crisis and if left unchecked it could be enough to deny the European single currency any benefit from the possibly pending normalisation of ECB monetary policy, although it’s also a risk that can be addressed by plans that the ECB already has in place.

“That is a potentially serious issue. But we do not see it as an imminent risk even for fiscally challenged euro members such as Italy. Like many other central banks, the ECB has gobbled up virtually the entire increase in public debt since 2015,” says Holger Schmieding, chief economist at Berenberg.

“We expect the ECB to stick to its vow to reinvest the proceeds from maturing bonds until end-2024. If the ECB wanted to shrink its balance sheet, it could do so by offering less generous conditions for its targeted long-term refinancing operations,” Schmieding wrote in recent research.

The ECB announced in December that it would continue reinvesting the proceeds it receives from national governments each time a bond held on its balance sheet reaches maturity, and sticking with this policy throughout the period in which its interest rates are being lifted could provide policymakers with a valuable and Euro-supportive mechanism for shielding Euro area economies from what the ECB refers to as “financial fragmentation.”

That would distinguish the ECB from central banks like the Fed, BoE, Bank of Canada and others, which have either already announced plans to extricate themselves from national bond markets or are currently in the process of crafting them, but it wouldn’t necessarily be a negative for the Euro if it enables interest rates to rise from historic lows without stoking concerns about solvency in the less financially resilient parts of Europe.

Above: Euro-Dollar rate shown at monthly intervals. Click image for closer inspection.