ECB’s exchange rate guidance: a game changer? Probably not.

Posted on 17. Mar, 2014 by Jean Jacques Ohana in Weekly Focus | Comments Off

Last week, we experienced an interesting turnaround in the ECB communication. For the first time, the ECB expressed its concern regarding the level of the exchange rate, arguing that the euro strength aggravates the problem of insufficient inflation. The speech has had the desired effect on the euro but the impact has been quite short-lived, as the EURUSD is now resuming its march to 1.40. As a matter of fact, Riskelia’s scores on EUR/USD and European currencies (CHF, GBp, SEK) remains strong (figure 1).

We have outlined in August 2013 the powerful structural factors supporting a stronger euro: positive eurozone current account (figure 2), shrinking ECB balance sheet (figure 3), higher real rates (figure 4) compared to other developed countries (US, UK, Japan)… To these structural factors, we have to add now the accumulation of bad news regarding the state of the US and Chinese economies (figure 5) and the potential economic consequences of the looming escalation in Ukraine. All these new concerns could further postpone interest rates hikes in the US and could even challenge the QE tapering.

This is not the first time a Central Bank tries to counter the appreciation of its currency. The SNB similarly did this with success in 2011. However, it had at the time shown its readiness to act, by increasing its holdings of currencies, bonds, stocks and gold to nearly 500 billion Swiss francs, almost the size of the nation’s gross domestic product.

Regarding the Eurozone, we think words won’t be enough to curb the appreciation of the single currency. Indeed, absent an increase in the ECB balance sheet, the structural and short-term factors will continue to support a stronger euro. Each ECB’s effort to talk down the euro will be followed by a short-lived consolidation, followed by a retracement and a subsequent speech, up to the point where speeches will lose credibility and actions will become necessary. It is hard to know if the tipping point will be when EURUSD reaches 1.45, 1.50 or more. A lot will depend on the evolution of inflation figures: a further weakening of inflation would erode the absurd excuse of “the absence of deflation evidence” to justify inaction.

Figure 1: Riskelia’s scores on G10 Currencies.

Figure 2: Current Account Balances expressed as % of GDP.

Figure 3: Balance Sheets of ECB (in Bln EUR) and Federal Reserve (in Bln USD).

Figure 4: US, UK and Euro Zone 10 years inflation linked bonds yields (10 years real rates).

Figure 5: Citigroup Economic Surprise Index in US, China and Euro Zone.


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