…to credibly talk down the euro
Despite recent attempts, we don’t believe the ECB will be able to credibly talk down the euro. We look for more EUR/USD upside in quarters to come, targeting 1.30 this year.
There are three key hurdles why the ECB won’t be able to credibly lean against the EUR:
- Despite recent ECB officials’ comments, the euro is in fact not strong. While EUR/USD is up by 4% over the past 6 months, the trade weighted euro (which matters for the ECB) is in fact largely flat.
- The potential disinflationary effects of a stronger euro are likely to be mitigated by the rise in the oil price.
- Drivers of exchange rate moves matter. Given the latest strengthening of the euro is also partly a function of solid EZ economic growth, such a strengthening should do less harm to the economy.
If the recent rise in EUR is unlikely to have a detrimental effect on both EZ inflation and the economic outlook, it should not lead to a downgrade of the ECB staff inflation and growth projections at the next ECB meeting on 8 March.
This in turn means that President Draghi won’t be able to credibly talk down the euro and credibly threaten a looser policy stance. This would be hard to justify in the absence of deteriorating inflation and growth outlooks (within ECB staff projections).
All this means that more ‘brutal’ and broad-based EUR strength from here is needed for the ECB to act. How to define ‘brutal’? In our view, the ECB would consider as brutal such a move in the trade weighted euro that would knock 0.3% off its 2020 CPI forecast (currently 1.7%) thereby undermining the ECB’s hope for sustainably higher inflation.
We estimate that for the 2020 CPI forecast to be revised lower by 0.3%, other things being equal, we would have to see a 4% rise in the trade-weighted EUR between now and early March. This would then cause a meaningful downward revision of the ECB staff inflation forecast and in turn justify a more dovish ECB stance.
While another (and fast) 4% rise in the trade-weighted euro may be the pain threshold for the ECB that could prompt a credible backlash, we notethat the pain threshold for EUR/USD may be much higher and will very much depend on the driver behind EUR/USD strength.
If the general USD weakness continues to be one of the prime drivers behind EUR/USD strength, then the ‘headline’ EUR/USD gains don’t have to fully spill over into trade-weighted EUR gains. This is because: (a) USD forms only 17% of the euro basket; (b)EUR does not have to necessarily appreciate against the European FX part of the euro trade-weighted basket; and (c) EUR does not have to record as large gains against the USD-bloc currencies as it does against USD as the broad-based USD weakness is also in play against the likes of CNY.
Indeed it may well be that EUR/USD has to strengthen materially in excess of 4% before the trade-weighted euro is actually up 4%.
On a valuation basis, we note that the recent EUR/USD rise did not bring the EUR/USD into extreme territory and the cross still looks undervalued on a long-term basis.