Euro parity calls fade away even as ECB set to pile on more stimulus

March 8, 2016

The European Central Bank is set to open its monetary stimulus taps even wider this week but the euro isn’t likely to budge very much.

A year back, just as the ECB fired up the presses to print over a trillion euros, many currency strategists at some of the largest banks had predicted the single currency would reach or breach parity to the U.S. dollar by about now.

Instead, after falling sharply in the run-up to the ECB’s bond purchase programme, the euro held firm for most of the last year. That came despite a U.S. Federal Reserve interest rate hike twinned with an even more negative deposit rate from the ECB and an extension of its QE programme into the future.

Those parity calls are now rapidly fading away.

By this time next year, the euro is forecast to trade not far from where it is now, according to the median forecast in the latest Reuters poll, which proved very accurate a year ago. In the March 2015 survey, the median consensus for the euro in a year was $1.08, just 2 cents off where it was on Tuesday.

The prevailing outlook for monetary policy — gradual rate hikes in the U.S. through 2016 and persistent policy loosening in the euro zone — suggests calls for the euro falling to $1 or below are even less likely to prove correct.

At least six prominent banks have abandoned parity calls over the past three months. The total now calling for parity or below is less than half the over 20 a year ago, when the ECB started buying 60 billion euros a month of mostly sovereign bonds.

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The trouble is, a relatively weak exchange rate is important to the ECB, even if it doesn’t say so.

A weaker euro makes imports costlier, which should boost inflation that’s turned negative again. It also makes exports more competitive in global markets — at least in theory.

Experience from Japan, where the central bank has spent much of the past decade printing trillions of yen, suggests the currency effect from QE isn’t very solid.

The Japanese yen has weakened only in short spurts and inflation hasn’t risen in any meaningful way.

Sporadic reports of the U.S. economy losing momentum aren’t helping much either.

Against Fed policymakers’ predictions of four rate hikes this year, economists now expect only two. Market pricing is even more pessimistic.

All of this has sucked the wind out of the dollar rally. Unless the U.S. economy really picks up speed, it is hard to justify any bias toward euro parity predictions.

History also suggests otherwise. The single currency last fell through parity 16 years ago, just after it was launched. It has managed to stay above one dollar since 2002 despite two recessions and a sovereign debt crisis that threatened to tear apart the single currency.

Apart from a sudden downturn in the economy, the biggest immediate risk to forecasts of a rising or stable euro might just be the possibility of the UK voting to leave the European Union in a June 23 referendum.

If Britons vote to break away, ensuing damage to the European project, and with it the currency, could be severe enough to drag the euro towards parity or lower.

Whether or not ECB President Mario Draghi can give markets what they want this week will provide much of the short-term direction. Both another deposit rate cut and more QE — the latter of which was met with staunch opposition from German members of the Governing Council in December — may be tough to deliver.

But the chances are rising.

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Vasileios Gkionakis, Head of Global FX Strategy at UniCredit in London summed it up this way in a note to clients:

If Mr. Draghi highlights (the sharp drop in inflation expectations) as an important development that needs to be monitored closely, then the market will interpret it as increasing the odds of additional policy action: in such a scenario the euro will come under downside pressure.

But we think it will be limited because 1. the market is becoming increasingly aware of its undervaluation; and 2. the previous experience in December (disappointment over ECB action) will mean that investors treat any potential pre-announcement of further stimulus with caution.

However, if Mr. Draghi downplays the recent deterioration – attributing it to temporary falls in oil prices – then the exchange rate will come under material upside pressure.

 

(Analysis by Hari Kishan)

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