Euro strength is good news
Euro strength is good news
Euro strength is itself good news and reflects good economic news – as long as it doesn’t go too far or too fast.
Currency strength tends to reflect economic strength and today’s euro strength is no exception: Eurozone growth has matured from an export-led, weak euro story in the Eurozone Financial Crisis (EFC) of 2010-2012, to domestic demand in 2016-17, which we expect to continue in 2018-2019.
The strength of the euro owes to both a substantial current account surplus and returning flight capital, in turn due to three main factors in our view: Defusing the existential EFC that threatened the euro’s integrity; falling political risk following the French elections in 2017; and strong growth. Hence Eurozone capital flight into Switzerland and the US, and from Periphery to Core is now reversing, boosting the euro and stabilizing TARGET-II, intra-Eurozone imbalances.* This combination of inflows should support the euro and help offset the impact of QE tapering and policy normalization on Eurozone risk premia.
This is also good news for the rest of the world, because strong domestic demand in the world’s largest economies adds up to robust global growth. After the United States, the Eurozone is the world’s second-largest single-currency zone, with about 16% of global GDP. It is too large to rely on exports for growth. The Eurozone, China and Japan each generate about 3% of GDP current account surplus. Still-larger Eurozone external surpluses would likely imply excess global exports and savings as well as deflationary pressures.
Euro strength implies continued easy global financial conditions: The flip side of euro strength is dollar weakness. The dollar remains the most important funding currency for Emerging Markets, which account for two-thirds of global growth and half of global output. Most EM cross-border activity is still dollar-linked — trade itself, trade finance and letters of credit are still mainly conducted in dollars; most hard currency debt is in dollars; and most domestic debt and equity flows use the dollar as a base currency.
A hard euro implies easy-does-it ECB policy normalization, because of the risk of excessive appreciation: Euro strength reflects political stability and strong growth, but would also put downward pressure on both core and headline inflation. Excessive or rapid euro appreciation, especially against the dollar, would likely tighten financial conditions, undermining growth. Both factors call for the ECB to move slowly and carefully.
Indeed, in response to the euro’s rally, some ECB Governing Council members have already been signaling that they prefer to delay rate hikes, even if the ECB brings forward the end of QE. These inclinations found voice once again at the most recent ECB monetary policy meeting on January 25: The Governing Council maintained its aim to taper asset purchases and left open the possibility of accelerating the end of QE. But during Q&A, ECB President Mario Draghi hinted that the pace of euro appreciation could delay rate hikes, implicitly because a strong euro’s impact on import prices and contribution to tighter financial conditions could keep inflation below target for longer than otherwise.
Keeping rates low should help maintain accommodative financial conditions in the Eurozone and globally. Yet, gradual normalization would bring ECB policy into line with the Fed, which would weaken the dollar.
Dollar policy is at best mixed, and on balance euro supportive. There are of course other factors at play, particularly US macro policy, above and beyond the Fed. The impact of the US tax reform on repatriation of retained earnings held overseas and on cap-ex both by US and foreign firms imply greater capital inflows into the US, and all else equal would probably imply dollar strength in the short to medium term.
However, other aspects of US policy may well continue to limit dollar upside. These include the prospect of a weaker US fiscal stance late in the business cycle, combined with a larger current account deficit if in fact the tax reform spurs. Wider US fiscal deficits typically require a significantly hawkish Fed and higher real interest rates than in other major economies to generate dollar strength, as for example during the 1986 dollar bull run. But at present, if anything, the opposite holds: If anything, global real rates and expected inflation and interest rate differentials across major economy yield curves are if anything converging, as monetary policy normalizes with the ECB’s QE tapering and the BoE’s first rate hike.
Furthermore, the US yield curve has been flattening, with the short end rising even as overall yield levels rise. We believe a similar process is starting in the Eurozone as well, given that there is plenty of slack to absorb in the economy and that core inflation remains subdued despite above-trend growth. This trend has even further to go to be fully reflected in Euro-government bond curves relative to the US, given higher rates of unemployment and stronger upside growth performance and lower initial levels of policy rates and yield curves. This joint yield-curve flattening process implies a limit to the degree of Fed tightening relative to the ECB, a factor which should also limit the dollar’s attractiveness relative to the euro.
Finally, the Trump administration’s mixed signals on the dollar are far less supportive than the consistent “strong dollar mantra” that had prevailed since the Clinton Administration. The market has recently re-focused on dollar policy in view of the Treasury Secretary Mnuchin’s comments in Davos that a weak dollar is good for US and global trade growth – even though he also indicated that dollar strength would prevail, given central bank and private demand for dollars based on strong growth. President Trump’s attempts to row back on weak dollar policy comments had a mixed impact, since his preference to lower trade deficits is well known, and his early presidential tweets about how the strong dollar “is killing us” were well read. Furthermore, Commerce Secretary Ross had in effect verbally intervened in FX markets several months ago when he suggested that the Mexican peso was excessively cheap. We are dubious about the efficacy of verbal intervention, but such mixed signals may both constrain dollar strength and boost currency volatility.
* TARGET-II is the real-time gross settlement (RTGS) system owned and operated by the Eurosystem. TARGET stands for Trans-European Automated Real-time Gross settlement Express Transfer system.
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