In July 2012, the future of both the Eurozone and its currency looked decidedly cloudy. At the time, the European Central Bank’s chief Mario Draghi famously stated that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
While the single currency didn’t immediately start flexing its muscles, Draghi’s declaration helped hasten the end of the sovereign debt crisis and bolstered the market’s financial confidence. Since then the euro’s recovery has at times been eclipsed by a strong US dollar – even as recently as 12 months ago, there was talk of the two currencies reaching parity – but begins 2018 in good shape.
Underpinning the currency’s revival have been three main contributing factors.
- After recession in several key Eurozone member states and meagre growth in others since the 2008-09 global financial crisis, the Eurozone’s economic growth is finally moving into gear.
- The ECB’s massive quantitative easing (QE) programme, with over €2 trillion of government and corporate bonds purchased since 2015 has underpinned the recovery.
- Inflation remains subdued for the moment, still well below the ECB’s 2% target.
Turning the tables
While Europe’s economic picture has brightened, the recovery has lagged that of the US where the Federal Reserve promptly turned on the QE tap in response to the global financial crisis. By the end of 2013 the Fed felt able to begin winding down or ‘tapering’ its QE programme. By the end of 2015, it felt emboldened to start gradually hiking up interest rates again.
The dollar strengthened in response, helped further by post-Brexit uncertainty and fears on more potential upsets from last year’s elections in the Netherlands, France and Germany. From a rate of €1=$1.3779 in December 2013, it advanced to a high of €1=$1.039 in December 2016 as analysts predicted that parity was imminent.
Yet that proved to be the high point. By last September, the euro had regained a rate of $1.20 and recent months have maintained the story of euro strength versus dollar weakness.
A resurgent single currency has already begun to alarm some major European corporates. France’s cognac producer Remy Cointreau warned last week that the euro’s strength against the US and Chinese currencies was “very brutal” and would dent the group’s full-year profits, despite healthy sales.
Draghi is aware of these concerns – and the likelihood that more corporate profit warnings will follow in the coming weeks, says Phil McHugh, trading floor manager for FX broker Currencies Direct. He expects a softer tone from the ECB chief when its governing council meets on Thursday, even if that will probably do little to slow the euro’s upward trajectory.
“The ECB is looking to pursue normalisation and 2018 will be a major stepping stone,” says McHugh. “It means exiting the QE programme and – further ahead – policy tightening and rate increases. But it probably won’t be until the meeting in March that members confirm they’re looking to end QE.
“Meanwhile the markets are getting a little ahead of themselves and have already started pricing in normalisation.”
Onwards and upwards
McHugh says that there is surprise at just how strongly the euro has appreciated against the dollar over the past year. “This may bring the euro/dollar rate down very slightly in the near term.
“But €1=$1.20 is the new base and we’ll see that moving towards $1.28 over time.” Should German chancellor Angela Merkel’s negotiations to clinch a new ruling coalition government prove successful this will further underpin the euro, although the markets are anticipating that a deal will be agreed.
So businesses are learning to live with a stronger euro. And with a growing number of invoices denominated in euros, more companies are actively hedging their currency exposure.
The euro’s strength against the dollar might seem unlikely, given that the ECB cuts its main interest rate from 0.5% to zero nearly two years ago – and few expect it to start raising rates again earlier than the second quarter of 2019.
By contrast, the Federal Reserve is two years into its latest interest rate hiking cycle, with the markets pencilling in at least three more increases in the benchmark US rate this year.
Yet the dollar is under some pressure, despite the US economy’s strong performance says McHugh. Last month’s announcement of big tax cuts for America’s multinationals will see the country’s deficit expand further and the rate of inflation has started to pick up. A higher than expected 0.3% monthly increase in December pushed the year-on-year rate to 1.8%.
By contrast, the Eurozone’s annual inflation rate last month eased from 1.5% to 1.4%, still comfortably below the ECB target rate of 2.0%, while underlying inflation – which excludes volatile energy, food and tobacco – was just 0.9% for the third successive month.
So the euro’s ascent is set to continue. However to add a sense of perspective, the euro was also in the ascendant a decade ago as the US economy reeled from the subprime crisis. Breaking $1.40 for the first time in September 2007, it peaked at over $1.60 the following summer.