Trading at 1.18/1.19 to the dollar, the euro has become a pricey currency. But the European currency has also gained against all other currencies as its effective exchange rate has returned to levels unseen since the end of 2014. So we can no longer count on the euro losing value. This makes the ECB’s job harder as a strong euro allows for importing disinflation, thereby pushing back the chances that inflation in the euro area will swiftly converge towards the 2% target set by the central bank.
We can make three initial remarks on this situation.
The first is that the euro’s swift rise looks like a monetary restriction. Monetary policy has become more restrictive and the ECB’s stance must confirm its aim for accommodation in the long term so as not to increase potential expectations on a change in course. The second remark is that a strong euro is coherent with the euro area’s very high external surplus. The decline in the euro was not compatible with this surplus. The last remark is that the dollar is weak. Its effective exchange rate is at its lowest since the end of 2016: America is not doing well.
Following on from these three remarks, we can derive three explanations to understand this currency movement.
The first is political.
At the end of 2016, investors expected a fairly weak euro. The main reason could be found in the very diverging political prospects between the US and the euro area. In the US, Donald Trump’s election and his ambitious fiscal policy to drive economic stimulus contrasted with the risk of populism on the old continent. Elections that lay ahead in Austria, the Netherlands and especially France left little room for doubt on the arrival of a populist and anti-euro party in one of these three countries. Investors opted to look to the potential improvement in the US economic outlook with a swift toughening of monetary policy, in view of the risk of a break-up of the Eurozone. The dollar had every reason to be robust and the euro to fall below parity with the greenback.
However, this is not the scenario that emerged.
Economic policy is currently non-existent at the White House and the economic cycle is flagging despite very low unemployment. This is a point of great interest for historians: six months after the arrival of a new president to the White House, there is still no sign of economic policy. This is a disaster and is probably a one-off in history.
In the euro area, the scenario that emerged pushed aside all populist parties from power. The risk of a break-up of the area is now very small, as Europeans are in favor of Europe. This is what recent elections have shown, particularly in France but also in the various polls carried out. The political balance has changed incredibly in the space of six months. The euro no longer has any political reason to be weak and the dollar has no political reason to be strong.
The second reason is a result of the first.
Political initiatives taken by Macron and Merkel point to the desire to strengthen the euro area’s institutions in order to make them more sustainable and more efficient. The Eurozone looks like a potentially stable area. At the same time, instability has materialized in the UK, as Brexit negotiations now look very unsure. There is also major instability in the US where the federal government and the states are in conflict, and we are also seeing the government go back on its commitments and adopt a sometimes combative stance on trade agreements e.g. in recent threats towards China. The euro area emerges as a haven of political stability and financial calm with the ECB. This is a key aspect for investors, and strengthens the European currency.
The third reason comes from monetary policy.
The Federal Reserve looked more hesitant on the need to hike its interest rates. The balance between fiscal policy and monetary policy is not what was expected at the start of the year. When fiscal policy lacks drive to support economic activity, then the Fed’s policy must continue being accommodative. Meanwhile in the euro area, growth is being confirmed and could further step up a pace. Investors are therefore now envisaging that monetary policy accommodation will have an end-point. This viewpoint was confirmed by the probably excessive interpretation of Mario Draghi’s comments at the ECB forum in Sintra, where he talked about forthcoming normalization in monetary policy. While the ECB president later went back on his comments, a line has been crossed in the euro area. If growth continues, the ECB will have to toughen its stance at some point in the future, and this time is not as far away as had previously been thought.
This new distinction in monetary policy expectations points to a slightly stronger European currency than before.
So the euro area looks more positive from a political standpoint – more united, more coherent and also more stable than the US.
This shift is set to be a long-term change as we cannot see Donald Trump radically changing over the months ahead, while at the same time, everyone wants to believe in a more integrated euro area. The euro is set to remain strong and could gain further ground. This is why we should not expect less monetary accommodation from the ECB over the months ahead, in fact the tone is set to be quite the opposite so as not to hamper the euro area’s robust recovery.
This is the translation of my weekly column for Forbes. It can be read here in French