For once, uncertainty on euro is welcome
london — The euro powered above $1.20 for the first time in over two years last Tuesday, sowing doubts over how the European Central Bank might respond at a policy meeting next week. But for once, investors in almost all markets will welcome the increased uncertainty.
Financial market volatility is creeping up as North Korea fires more missiles, Donald Trump’s presidency slips even further into chaos and away from passing any market-boosting reforms, and the traditionally choppy month of September looms.
In that light, any prospect that the ECB will delay the process of winding down its bond purchases — essentially pushing back its return to policy tightening — will be met with a sigh of relief.
With the 19-nation eurozone economy at its strongest in six years, policymakers want to begin the process of reducing their bond buying, thereby gradually removing the huge monetary stimulus that has largely underpinned that very recovery.
The ECB began its asset-purchase scheme in March 2015. It has so far bought around €2.3 trillion of bonds. It is expected to begin winding down the programme in early 2018, but inflation and inflation expectations remain well below two per cent.
The rising exchange rate complicates attempts to “normalise” policy, however. It dampens already weak inflationary pressures as it is effectively a tightening of policy, which lessens the urgency to taper.
According to economists at French investment bank BNP Paribas, a 10 per cent rise in the euro corresponds with a fall of nearly 0.5 percentage points in inflation over the next 12 months.
When the ECB last met on July 20, the euro was at $1.15. ECB President Mario Draghi said then that the rising exchange rate had received “some attention” from policymakers.
Tuesday’s rise in the euro above $1.20 for the first time since January 2015 means the currency is now up 15 per cent against the dollar this year and almost five per cent on a trade-weighted basis. It is on course for its biggest yearly rise since 2003.
But Draghi made no mention of the euro or of his policy intentions at Jackson Hole last week. Federal Reserve Chair Janet Yellen adopted a similar vow of silence on US policy, which markets interpreted as “dovish”.
The Fed’s apparent caution over raising rates much further and reducing its balance sheet trumped Draghi’s lack of policy steer, pushing US yields and the dollar lower. In some ways, the ECB is powerless to stop the euro’s rise.
Investors, especially equity investors, will hope the higher exchange rate stays the ECB’s hand on tapering. According to Deutsche Bank, every 10 per cent rise in the trade-weighted euro lowers earnings per share by five per cent. Full-year 2017 earnings revisions have turned negative this summer. —