Carsten Brzeski's blog

ECB’s Sisyphean task…

…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:

  1. 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.
  2. The potential disinflationary effects of a stronger euro are likely to be mitigated by the rise in the oil price.
  3. 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.

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