MacroScope

Hopes for a weaker euro looking more like fantasy

December 9, 2013

Hopes that the soaring euro will eventually fall and help the economy with a much-needed export boost for struggling euro zone nations are looking more and more like fantasy.

The collective talk about its inevitable drop is beginning to sound much like the drum-beat of opinion lasting more than half a decade that said the yen would fall while it stubbornly marched in the other direction.

Only the most spectacular fusillade of Japanese central bank cash in history managed to turn the situation around, and even now the yen is barely trading much weaker than the most conventional of predictions a few years ago.

The latest Reuters FX polls show swathes of the world’s top forecasters standing shoulder to shoulder predicting the euro will fall. The questions left unanswered are why and how.

After all, if a surprise interest rate cut to near-zero leaves the currency 2 percent higher only a month later, what exactly is supposed to happen that will push it the other way?

The problem is the euro has become the victim of its own bare-boned success – so successful that it’s the best-performing major currency this year.

When European Central Bank President Mario Draghi bellowed out, selectively choosing the foreign exchange capital of the world as his venue, that he would do everything it takes to save it, the world took notice.

Now the optimism that surrounds the nascent euro zone recovery, and a stock market rally across the continent that has brought hundreds of billions of investment into euro-denominated assets, has pushed the euro higher.

This is exactly what Draghi wants and what he doesn’t want.

In order to get the recovery needed to bring down eye-wateringly high unemployment and get Europeans back to work and spending again, the euro zone needs to be more competitive. Making its exports more costly is not the way to do it.

Indeed, a stronger euro is slowly killing off European economies that need to sell to the world to survive.

At the same time, the euro’s strength is in large part a reflection of those foreign inflows after years of selling that are ensuring Europe’s banks and its governments remain solvent.

What is increasingly clear is that a lot more than a surprise 25 basis point interest rate cut will be required to turn the situation around.

So far there is nothing on the immediate horizon in Europe apart from the possibility of more cash on offer for the euro zone’s banks.

Of course what is likely to happen soon is the first move by the Federal Reserve to cut back on its mammoth monthly bond-purchase programme, and that will almost certainly prop up the dollar at the expense of every other currency.

But will that move be enough? If the Fed’s move to taper really will weaken the euro, we probably ought to be seeing signs of that priced into the market now.

And if the ECB has to wait for another central bank to get on with its policy shift before Europe can even begin to dream of serious improvement, how independent can it really be?

Japanese or U.S.-style quantitative easing, ferociously opposed by Germany’s central bank, almost certainly won’t happen in Europe. That is pretty well understood and in that way the ECB has forged its own path.

But with an extremely uneven recovery and very weak growth, it is a dangerous one to take.

“Euro strength has done the European economy no favours – no thank you card for that – and is adding to the deflation risk in Europe‚Äôs periphery,” said Vincent Chaigneau, head of FX and rates strategy at Societe Generale. “Either the ECB will turn bolder in 2014, or policy inaction will backfire and threaten stability.”

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