Many at the ECB continue to jawbone the euro. While this may help slow the single currency’s gains, we believe it will have limited lasting impact as the fundamentals favor a stronger euro over the near-term. Furthermore, we do not think that the scale of those gains warrant a panicked response from policymakers just yet.
The ECB debate over the strong euro is by no means settled. At her post-meeting press conference, Madame Lagarde said the ECB discussed the exchange rate but agreed that there is no need to overreact to its gains. She added that the bank does not target exchange rates but will “carefully assess” the impact on inflation. On the other hand, ECB Chief Economist Lane warned that same day that the strong euro has dampened the eurozone inflation outlook. He later reiterated his concerns and predicted that inflation will remain negative for the rest of the year, adding “It should be abundantly clear that there is no room for complacency.”
Others have since weighed in. Bank of France Governor Francois Villeroy de Galhau said that the exchange rate “does matter for inflation and monetary policy” and will have to be monitored. Over the weekend, Bank of Finland Governor Rehn and ECB Vice President de Guindos also expressed concerns about the exchange rate. Indeed, Lagarde was forced to do a bit of a walk-back and said there would be no complacency about its price stability goal.
To keep things in perspective, note that the euro has gained about 6% YTD against the dollar, 3% against the yen, and 8% against sterling. As we shall see below, the gains so far are nowhere near the “brutal” moves that former ECB President Trichet lamented. As such, it is too early to push the panic button but the yellow lights are flashing. We suspect the next wave of concern will emerge if the euro approaches the $1.25 area, as we expect. That is about when the magnitude of euro gains will match those of early 2014, when then-ECB President Draghi expressed concern with the exchange rate.
Charts point to further euro gains near-term. The euro traded last week near $1.2010, the highest level since May 2018. The dollar made a brief comeback but is back under pressure this week. The euro needs to break above the $1.1910 area to set up a test of last week’s high. Looking further out, long-term charts point to an eventual test of the February 2018 high near $1.2555. That is as far as we will go right now, as we are reluctant to call for a broader dollar downturn just yet.
Recall that we remain negative on the dollar due to the inability to get the virus numbers down here in the US. Those virus numbers have stabilized a bit, but in our view not by enough for the economy to pick up momentum again. Weekly jobless claims show a growing number of claimants for unemployment benefits, both initial and continuing. The labor market simply hasn’t healed yet and the pace of job creation is slowing. With unemployment benefits by executive order running out this month, the outlook is getting grimmer, especially with no consensus yet on another round of fiscal stimulus. These developments will underscore the Fed’s ultra-dovish outlook, and that stance will be reiterated at this week’s FOMC meeting. We continue to believe that all of these factors will serve as headwinds on the economy as well as on the dollar.
Euro positioning is getting extended. CFTC data shows net euro longs for non-commercial accounts at 197k contracts for the week ended September 8. This is down just a touch from the peak near 212k for the week ended August 215 but it’s still high. For comparison’s sake, net euro longs stood at -114k in late February and so the swing in positioning has been quick and significant. As a result, we believe further gains may get tougher and tougher from a positioning standpoint. Perhaps we are looking at a slow slog rather than a quick spike.
A BRIEF HISTORY LESSON
During the early stages of the financial crisis, the Fed was first and foremost in cutting rates to zero and starting Quantitative Easing (QE). It began the easing cycle with a 50 bp cut to 4.75% in September 2007. This was followed by 25 bp cuts at each of the next two meetings in October and December. The Fed continued cutting in early 2008, taking the Fed Funds rate to 2.0% in April. The Fed stood pat until October 2008, when it delivered two 50 bp cut to 1.0%. The Fed first started Quantitative Easing (QE) in November 2008 when it announced plans to purchase $600 bln of agency mortgage-backed securities (MBS). At the December 2008 meeting, the Fed cut rates one final time and move to a range of 0.0-0.25% for the Fed Funds rate. That’s where rates remained until December 2015.
What did the European Central Bank do during this same period? Believe it or not, it was still hiking. Governor Jean-Claude Trichet ignored development in the US and hike rates 25 bp in March 2007 and again in June 2007, taking the ECB’s policy rate to 4.0%. The ECB delivered one last 25 bp hike to 4.25% in July 2008. However, it was forced to start cutting rates with a 50 bp move in October 2008. Over the course of 2008 and 2009, the ECB slashed rates to 1.0% by May but then stood pat until April 2011, when Trichet started another tightening cycle with a 25 bp hike to 1.25%. Another 25 bp hike to 1.5% followed in July 2011 but that’s as far as it got. The eurozone crisis erupted and the ECB reversed and started cutting rates in November 2011 and took the policy rate to zero by March 2016. That’s where rates remain now.
ECB President Jean-Claude Trichet used the word “brutal” to describe steep euro rallies on several occasions. The first time he did this was in early 2004 after the euro rallied from a low of $0.8565 in February 2002 to nearly $1.30 in February 2004. He did so again in November 2007 after the euro rallied from a low of $1.1640 in November 2005 to nearly $1.50 in November 2007. In both instances, the euro initially fell only to recover and go on to record even higher highs of $1.3665 and $1.6040, respectively. It wasn’t until the Fed started hiking in July 2004 and the ECB started cutting rats in October 2008 that the exchange rate trajectories shifted.
And it wasn’t just Trichet. His successor Mario Draghi cited euro trade-weighted gains of more than 10% over the course if 18 months in early 2014 as a “cause for serious concern” in light of low inflation. Of note, the euro rallied from a low of $1.2045 in July 2012 to a high near $1.3965 in March 2014. It went on to nearly touch the $1.40 area in May 2014 before falling sharply in H2 2014. Here too, the euro’s reversal was due to shifts in monetary policy stances, though in this case it was not only the ECB cutting rates but also setting the table for joining the Fed in conducting Quantitative Easing (QE).
Now, it’s Madame Lagarde’s turn in the spotlight. Her initial stance of indifference is warranted in light of the rather limited euro gains seen so far this year compared to past moves that were clearly much more “brutal.” Yet what’s also clear is that without any changes in the underlying interest rate differentials or economic fundamentals, jawboning will have limited impact on the euro exchange rate.