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European Central Bank More Concerned about Interest Rates than Euro Rate

by internationaldirector

Written By: Darren Morris – Corporate Finance

The euro currency has gained more than 10 percent this year against the dollar.

Recently, the euro’s increase in value even accelerated after breaking the psychological bar of US$1.15. It reached $1.1665 on July 21, the highest level since January 14, 2015. Since the beginning of the year, it has gained 10.4  percent. The range between $1.5 and $1.20 per euro seems to be the currency’s new comfort zone.

As a sign that confidence is gradually returning in the euro area, investment flows are supporting the euro. Indeed, in May and for the seventh consecutive month, foreign investors bought €46.9 billion worth of euro area equities, the largest amount since December 2015. At the same time, euro area investors bought €14.6 billion worth of foreign equities—so that the euro area, and therefore its currency, benefited from a net change of €32.3 billion. On the other hand, for bonds, the eurozone is still suffering net outflows of €40.6 billion. This is largely due to the large purchases of foreign bonds by Europeans (€41.3 billion), while foreigners returned to buying European bonds in May, for the first time in four months.

“Traditional fund managers have followed suit with hedge funds and have started selling dollars to buy euros,” explains Stephen Jen of Eurizon SLJ Capital. The big question is whether central banks, with little exposure to the euro, will increase the share of their reserves invested in the single currency. If this is the case, the progression of the single currency is far from over

According to the ECB’s (European Central Bank’s) survey of economists, professionals are more optimistic about business. They have revised their real gross domestic product (GDP) growth forecasts for the euro area in 2017 and 2018 to 1.9 percent and 1.8 percent respectively, by 0.2 percentage points. On the other hand, they have revised their inflation expectations (excluding food and energy) very modestly from 1 to 1.1 percent this year. They have maintained their expectations of a price increase of 1.3 percent in 2018 and 1.5 percent in 2019.

The European Central Bank seems more concerned about the interest rate than the currency rate.

The ECB is still targeting a rate of inflation of 2 percent, but the reality is still far from that. According to the ECB, the recovery in the eurozone has not yet been able to drive up prices. The inflation observed is still too closely linked to oil prices. In addition, not all countries in the euro area are in fairly good health—evidence for the ECB that the economy still needs its support policies.

However, while the euro has just reached a new peak against the dollar, long-term interest rates are also on an upward slope. And if the currency level does not seem to disturb the ECB, interest rates are more a worry. On June 27, they were at 0.38 percent for the 10-year German bond, jumping to 0.57 percent on July 10, only to slowly fall back. They were 0.48 percent on July 19. The shock of the jump in the French Treasury bond was more severe: 0.63 percent on June 27, 0.97 percent on July 10, 0.85 percent on July 19.
In fact, it seems that ECB President Mario Draghi himself triggered the financial storm on June 27 in Sintra, Portugal, during his introductory speech at the seminar on central banking—in front of definitely very reactive listeners. “With the continued economic recovery…the central bank can accompany the recovery by adjusting the parameters of its monetary policy instruments—not in order to tighten its direction, but to keep it broadly unchanged.” These words obviously meant that, since things were going better, the European Central Bank was going to revisit its mechanism somewhat in the months to come, but still keep it accommodating.

The financial markets understood that, as things were going better, the ECB could reduce its accommodative policy. The markets recalled that during a past similar situation in 2013—when Ben Bernanke, former chairman of the US Federal Reserve, had not even finished his speech mentioning that purchases of treasury bills by the Fed should be reduced one day—long-term rates began rising, creating a mini-global crisis.

The ECB immediately tried to calm down investors. But the decline in yields is still not there, although Mario Draghi was very clear on July 20: “We decided to leave the key interest rates of the ECB unchanged. We expect them to remain at their current levels over an extended period of time, well beyond the time horizon for our net asset purchases. As far as non-conventional monetary policy measures are concerned, we confirm that our net asset purchases, at the current monthly rate of EUR 60 billion, should be realized until the end of December 2017 or beyond if necessary”.

For sure, the ECB will have to unveil its agenda, but how?

Nothing was said about the future of the large debt buyback program. “We did not discuss what we will do in September (…) and after,” said Mario Draghi during his press conference, even though the markets expected a few details about it from him.

The prospect of a stop, even a gradual one, is a delicate topic for the ECB to announce—because it will be necessary to avoid acknowledging that a rise in interest rates could cause a stop to the fragile recovery.


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