© The Financial Times Ltd 2015 FT and 'Financial Times' are trademarks of The Financial Times Ltd.
Last updated: March 13, 2014 6:55 pm
Who will blink first? Mario Draghi or currency traders?
A sharp rise in the euro this week has increased pressure on the European Central Bank president, who faces the challenge of pulling the eurozone out
of a potentially dangerous phase of extremely low inflation. The more the currency strengthens, the greater the downward pressure on prices.
Yet its latest appreciation was largely a result of the ECB’s governing council last week appearing to rule out fresh policy action in the near future – even though inflation was projected to remain well below the target annual rate of “below but close” to 2 per cent until 2016.
On Thursday, with the currency up more than 1 per cent since the ECB meeting, Mr Draghi moved to counter its strength, saying in Vienna that ECB “forward guidance” on interest rates would provide downward pressure. At around $1.39, the euro was at its strongest against the dollar since late 2011, but fell after his comments.
What happens next depends on the global forces driving the euro’s rise – unless Mr Draghi surprises markets again by unleashing measures to head off deflation risks. “The story isn’t over; he is just keeping his powder dry,” says Neil Williams, chief economist at Hermes.
The euro’s relentless rise is one of the market surprises of 2014. The consensus view at the start of the year was that the US economic recovery would leave the eurozone trailing, putting upward pressure on the dollar.
Instead, the euro’s continued strengthening has reflected the current account surpluses run by eurozone countries and the increasing investor confidence that the eurozone debt crisis is over. As investors fled emerging markets and with US equities looking expensive, the strengthening currency became an additional attraction.
Valentin Marinov, strategist at Citigroup, says: “People aren’t hedging [currency risks] at the moment when they buy European assets.”
Others say the euro has benefited from worries about a possible war over Russia’s incursion into Ukraine’s Crimea peninsular. “The relative instability to the east is making the euro look like a haven,” says Mr Williams.
Policy uncertainty in Japan and the Swiss central bank’s cap on the franc’s appreciation have made other havens less attractive.
The euro’s appreciation has gained its own momentum. Investors have lost money so consistently betting on its fall that “people have thrown in the towel”, says Bhanu Baweja, a UBS strategist.
“They used to have a very serious short . . . Now I find that people are just not trading the euro. They are battered and bruised, chastised and chastened.”
Last week’s ECB inactivity seemed another buy signal. In traders’ eyes ECB policies are at odds with those of other central banks. Even if interest rates are held stable, the ECB’s balance sheet is shrinking as banks repay loans taken out at the height of the eurozone crisis. The US Federal Reserve is still engaged in asset purchases even if the pace is slowing,
But some analysts wonder if the ECB’s message was misunderstood. They note that Mr Draghi discussed extensively the degree of slack in the eurozone economy – perhaps as a signal that fresh action remained possible. The ECB president also spelt out the disinflationary risks of currency appreciation. A 10 per cent trade-weighted appreciation in the euro typically reduced inflation by 40 to 50 basis points, Mr Draghi said. That was a “subtle form of intervention”, says Stephen Jen, head of SLJMacro Partners, a currency hedge fund.
“Occasionally the ECB fails to hit the spot in its press conference, and this may have been an example of that,” says Ken Wattret, economist at BNP Paribas.
Even if foreign exchange markets see the ECB remaining on hold, fixed income investors may be taking a different view. As the euro has risen this week, eurozone bond yields, which move inversely with prices, have tumbled – suggesting that at least some people are betting on ECB quantitative easing. “There is an obvious disconnect there [with currency markets],” says Mr Wattret. “They can’t both be right.”
Where the pain threshold lies is hard to judge. “My guess is that the ECB will act in the face of a debilitating move significantly north of $1.40,” says Simon Derrick, head of currency strategy at BNY Mellon.
A next step might be further verbal intervention by Mr Draghi to talk the currency lower. But the ECB could still pump liquidity into the financial system, impose negative interest rates on bank funds parked with it overnight – or move towards quantitative easing.
Chris Turner, ING strategist, says: “Markets react more to deeds than words, and we doubt that ECB rhetoric will be enough.”
Copyright The Financial Times Limited 2015. You may share using our article tools.
Please don't cut articles from FT.com and redistribute by email or post to the web.
Sign up for email briefings to stay up to date on topics you are interested in