Euro rockets with $1.35 in view as traders steamroll ECB defences

Euro
Central Bankers like to move together in a peloton, fearing a currency accident if anybody breaks ranks. This time the ECB came a cropper 

The euro has surged to a three-year high against the US dollar despite forlorn efforts by the European Central Bank to hold back the onslaught, making it even harder for the eurozone to escape its ‘lowflation’ trap.

The exchange rate smashed through powerful lines of technical resistance, reaching $1.1652 after traders disregarded a string of dovish comments by the ECB’s president Mario Draghi.

It has wiped out all the currency effects since the launch of quantitative easing – normally a ruse to weaken exchange rates – rising almost 10pc in trade-weighted terms since late 2014.

News the US special prosecutor Robert Mueller is expanding his probe into the business empire of President Donald Trump compounded the dollar's woes. Fears of paralysis in Washington are causing investors to wind down bets on tax reform and infrastructure spending.

Mr Draghi rowed back from earlier talk of a ‘reflation’ revival in Europe, insisting instead that monetary stimulus will be needed for a very long time and bond tapering will be glacially slow. “Let me be clear, inflation is not where we want it to be, and where it should be,” he said.

The bank restated that it “stands ready” to step up its €60bn (£54bn) programme of bond purchases each month if need be. Removal of this clause is seen as a pre-condition before addressing the timetable on tapering.

“This is a clear sign that the ECB does not want to pour more oil on the small taper tantrum fire seen in financial markets over the last few weeks,” said Carsten Brzeski from ING.

Yet Mr Draghi’s soothing words failed to do the trick.  Justifiably or not,  currency markets were watching to see whether he would flag the strong euro as a rising risk. “He absolutely ducked it. When they saw that, everybody piled into the euro,” said one trader.

Hans Redeker, chief currency strategist at Morgan Stanley, said the euro could go much higher if the eurozone’s political leaders agree on a ‘grand bargain’ to rebuild monetary union on better foundations.

Purchasing power analysis suggests that the equilibrium level for the eurozone as a whole is around $1.35 (and $1.54 for Germany). “We may have to think about that number if the German election in September really does lead to deeper EU political integration,” he said.

Most large companies use currency hedge contracts and are therefore cushioned against short-term moves in the euro. Any damage takes time to become evident, but ultimately some eurozone countries suffer more.  Italy is especially vulnerable since it competes toe-to-toe with China and emerging Asia in mid-level sectors that are sensitive to the exchange rate.  

Mr Draghi’s dovish tone was an attempt to bring the ECB back in the line with the ‘peloton’ of central bankers all clustered together as if it were the Tour de France.  The Federal Reserve, the Bank of England, and the Bank of Japan have all retreated from their ‘tough-love’ message at the Sintra conclave in Portugal last month, which many took to be a sign that the global monetary system was turning in lockstep.

“You don’t want be the last one standing. Your currency goes up and you get crushed,” said Marchel Alexandrovich from Jefferies.

The surging euro makes it almost impossible for the ECB to push inflation towards its 2pc target this decade. This has corrosive effects on the long-term debt trajectory of weaker states in southern Europe, and for France.

Headline inflation fell to 1.3pc in June. Core inflation that strips out energy and food is nailed to the floor at 1.1pc.

Mr Draghi’s comments were in stark contrast to ebullient language in early June when he said inflation tail-risks had “definitively disappeared” and labour markets were on the cusp of a wage spiral.

The ECB appears to have been rattled by a spike in borrowing costs over the last three weeks. Yields on 10-year German Bunds have jumped thirty basis points from 0.24pc to 0.54pc, with knock-on effects though the whole borrowing complex. “The last thing the Governing Council wants is an unwanted tightening of the financing conditions,” said Mr Draghi.

The announcement on bond tapering is likely to come in September or October, with purchases cut to €40bn a month in January and then phased out by the middle of 2018. By then the ECB will have exhausted the stock of German, Irish, Portuguese, Finnish, and Spanish bonds that it can buy under current rules.

Reinhard Cluse from UBS said the ECB’s balance sheet is likely to peak at around €4.75 trillion or 42pc of GDP. The Fed never dared to test such a high ratio.

It will remain at this level until 2020 when the emergency lending programme (TLTRO) starts to expire, with no interest rate rises until 2019.

What is remarkable is that the euro should be rising at all when policy rates in currency bloc are still negative and will remain so as far as the eye can see.

It is all the more puzzling given a recent study by the ECB showing that underlying unemployment is 18pc. There is more disguised slack in the labour market than previously thought. This would imply a slower rate of tightening.

But in the political beauty contest between Europe's Macron-Merkel ‘dream team’ and Mr Trump’s America, the Europeans are, for now, winning.

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