MacroScope

Strong euro may be a monster Draghi can’t tame

May 13, 2014

Mario Draghi, President of the European Central Bank (ECB), addresses the media during his monthly news conference at the ECB headquarters in FrankfurtECB President Mario Draghi may have created a monster when he declared nearly two years ago that he will do “whatever it takes” to save the euro.

Given that Draghi has now openly pegged the outlook for monetary policy at least partly to the exchange rate, the prospect of both short-term and long-term investors buying the euro is a worrying obstacle for policy.

A rampant euro is anathema to the ECB’s narrow mandate, which is aimed squarely at getting very low inflation back to its target of just below 2 percent. A stronger euro keeps a lid on the price of everything the euro zone imports from abroad. And it makes everything it exports seem relatively more expensive.

The ECB now appears hamstrung between two outcomes, both pointing to a strong euro.

If the euro zone economy relapses from its broadening recovery, and inflation remains dangerously low, speculators may be tempted to try their luck and see how far they can take the euro before a reluctant ECB steps in with a response.

Very few are betting that the ECB will print trillions of euros worth of money in a quantitative easing programme like the U.S. Federal Reserve has done, half a decade later. And it can only cut is main interest rate by a razor-thin amount, and its deposit rate below zero.

The ECB’s red line for the euro could be $1.40, or the $1.42 consensus in the latest Reuters survey of FX strategists. It could even be as high as $1.45, according to some.

But if the euro zone economy picks up, and presumably pricing power and inflation with it, flows into euro zone assets naturally will increase and the euro will rise.

BNP Paribas has observed through its recent client flows that speculators, as well as investors who take the long view, are having nothing of Draghi’s threat that he is ready to cut rates next month, or his warnings about the euro being too strong.

During the past week, traded volumes in G10 FX have remained muted. However, speculatively oriented clients such as hedge funds have become more active. Regardless of the ECB’s more dovish monetary policy stance, asset managers and hedge funds have bought the EUR. This stands in contrast to central banks and corporates selling it. We expect a positive capital flow situation to keep EUR downside limited from current levels. The USD was sold, especially by asset managers. It appears that firm demand for non-USD-denominated risk assets is keeping the greenback capped.

The euro has fallen a little over 1 percent since Draghi hinted that a razor-thin rate cut, which everyone knows won’t do much good, may be on offer in June.

But there is little evidence that it has dramatically changed course. There is only a very low chance of that happening until there is a seismic change in the outlook for U.S. interest rates.

Speculators jacked up their net long euro positions in the week running up to that policy meeting, according to the Commodities Futures Trading Commission, going short the dollar. More than 110,000 long euro contracts outstripped a little over 78,000 shorts.

There has also been a recent rush to buy securities – such as government bonds – from euro zone countries that were badly hit by the crisis. While that has pushed the euro up, sovereign yields, and so in theory, borrowing costs in the wider economy, will fall.

Ireland, which just recently emerged from a bailout, had benchmark sovereign yields trading below the equivalent UK security last week for the first time since the financial crisis.

The latest Reuters global asset allocation poll found U.S. fund managers increased allocations to euro zone shares in a model portfolio to a three-year high.

Cross-border mergers and acquisitions activity has totalled more than $400 billion so far this year, the second highest on record, according to Meera Chandan at JP Morgan FX research. The euro has been one of the main beneficiaries. Without any further easing, JPM expects M&A to continue supporting the euro.

Presumably that also is what long-term investors are betting will happen.

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