THE recent obsession with seemingly modest euro exchange-rate gains has more to it than meets the eye.
Small moves in currency values, such as the euro’s 4% trade-weighted rise this year, may seem like a sideshow during a pandemic that has triggered historic GDP collapses, 30%-40% round-trips in stock markets and a plunge in long-term borrowing rates.
But in a world of ever-decreasing monetary policy options, that sort of sideshow can take centrestage.
Already at near-zero interest rates or below, central banks appear reluctant to dabble further with the upside-down world of negative rates for fear the experiment will backfire on banks and have the perverse effect of increased saving.
All bond-buying guns are blazing to keep long-term borrowing rates depressed instead and one of the few remaining options now left is to convince markets that this will continue for years, even if inflation returns above 2% target levels for a period.
At least, that’s what the US Federal Reserve is planning,
Other central banks may simply have to follow that strategic shift eventually – however they nuance or badge it.
One reason they can’t allow the Fed’s aggressive battle to reflate the US economy go unmatched is that this would simply sink the dollar further – potentially deflationary in economies already struggling to keep annual price gains positive.
At about minus 1% on both sides of the Atlantic, for example, the premium on US over eurozone real or inflation-adjusted 10-year government bond yields effectively evaporated to zero from more than 1% pre-pandemic.
If exchange rates continue to track that gap, central banks succeeding in lifting inflation expectations should be rewarded with a weaker currency – at least in a world where nominal yields are now stuck.
Here’s where small exchange-rate moves start to matter, and why the European Central Bank (ECB) is gently but firmly turning up the volume on its protest at excessive euro strength.
HSBC’s currency team this week detailed why it thinks the euro’s seemingly modest 6% rise against the US dollar this year will be resisted aggressively by the ECB.
It argues that the euro’s contribution to tightening “financial conditions” in the bloc was larger than the dollar’s input to the US equivalent and that the ECB had been explicitly warning about financial conditions since euro/dollar started its surge toward two-year highs in June.
“The ECB’s focus has shifted massively towards financial conditions, ” they told clients, saying they examined all ECB statements for such mentions since the start of the year.
In a dire year for everyone, US growth, company earnings and asset prices are all still outperforming those in the eurozone and HSBC reckoned that merely underlined a mismatch between a euro trade weighted index at six-year highs with dollar’s only where it was last year.
Economy-wide financial conditions gauges, as seen by central banks, broadly measure both the cost and ease of access to all forms of finance. Indices capturing them tend to include short and long-term interest rates, credit spreads, equities and currency rates.
These indices remain negative, or tight, in the United States and eurozone despite massive policy loosening this year. However, the components and pressures differ in the two regions.
HSBC said the relationship between financial conditions and change in growth rates was more significant and stronger in the eurozone than in the US and the euro’s trade-weighted rise was the dominant force keeping overall conditions tight. The dollar’s current contribution to the US index was neutral by contrast.
“We would not be surprised to see the ECB put more emphasis on the currency given its lack of firepower to loosen financial conditions through other channels, ” the HSBC team added.
And there has indeed been steady drumbeat from ECB officials since last week’s meeting on how much the currency “matters”.
Goldman Sachs, for one, reckons the euro effect on financial conditions may hasten the next increase in bond buying.
“Substantial additional QE will be required beyond the current pandemic emergency purchase programme (PEPP) envelope to maintain loose financial conditions given persistently low inflation and increasing sovereign bond supply, ” Goldman economists wrote.
For others, the timing of when ECB reacts matters as much.
UniCredit’s chief economist Erik Nielsen reckons that even though models suggest the euro was close to fair value now, the aggressive long-term stance of the Fed meant the ECB needed to brace for a period of euro overvaluation that could send euro/dollar rising as high as 1.28 next year.
“That the ECB is uncomfortable with the stronger euro is pretty clear, ” he wrote. But “why didn’t the ECB get out ahead of the Fed with clearer communication on the policy path ahead?”
“As a central bank you really want to be ahead of such market moves, rather than ending up reacting to them.” — Reuters
Mike Dolan is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own.
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