Is the Euro Headed for a Big Correction?

May 7, 2014

It’s fitting on this eve prior to the May meeting of the European Central Bank Governing Council to examine the euro’s near-term susceptibility to a substantial turnaround.  Asked a month ago about how a strong euro might affect future policy decisions, ECB President Draghi had this to say:

The exchange rate is very important for price stability, so much so that we have made an explicit reference to it in the introductory statement, as you have seen, where we say that “… the Governing Council sees both upside and downside risks to the outlook for price developments as limited and broadly balanced over the medium term. In this context, the possible repercussions of both geopolitical risks and exchange rate developments will be monitored closely”. But, as I have said several times, it is not a policy target. It is an increasingly important factor in our medium-term assessment of price stability, but it is not a policy target. In this sense, we do not link our medium-term assessment to a precise level of the exchange rate. It is part of the overall information that comes into play when we undertake our medium-term assessment.

Yesterday, the euro traded within a half-U.S. cent of $1.4000, the closest to that psychological hurdle that it’s been since it last showed a $1.40 handle on October 31, 2011.  An elevated euro tends to depress import prices and the prices of import-competing goods produced domestically.  ECB officials have little tradition of talking about exchange market conditions, so exceptions to that norm really stick out like when former ECB President Trichet labeled the euro’s level “brutal”  towards mid-2008 when it was hovering near $1.60, which still defines the high end of the EUR/USD’s lifetime trading range.  The other extreme, $0.823, was touched in late October 2000.

The euro is not at so strong a level nor advancing at such an excessive rate to prompt policy changes to reverse its course.  Draghi’s above comment is much more subtle than the earlier Trichet protest as is fitting given that the euro was some 15% more expensive against the dollar back then.  Nor has the euro strengthened far above its year-to-date average of $1.373.  Likewise, the trade-weighted euro today, 104.73 is merely 0.6% above its year-to-date mean. It’s something for policymakers to monitor but not act on.  According to the most recent Economist update of its Big Mac index, the euro was only some 7-8% overvalued against the U.S. dollar.

More central to ECB officials is their view on inflation and the risk of deflation, which is determined by looking at many factors, including the exchange rate.  As they predicted a month ago, inflation bounced back to 0.7% in April after dropping from that level to 0.5% in March.  Core inflation returned to 1.0% from 0.7% in March, and the big difference in April from March is that energy posted a 12-month drop of 1.2% last month after a bigger slide of 2.1% in March.  Knowing what energy had done, officials were pretty sure overall inflation would not be as low in April as March. 

Looking forward to where inflation goes from here, officials are looking at Euroland’s economic recovery and a variety of indicators of expected inflation.  They’ve been quite consistent in preaching that all is well with expected inflation.  It’s understood that the longer actual prices rise less than target, the greater is the risk of a convergence of expected inflation downward toward the new and lower norm.  But evidence of that happening so far hasn’t materialized.  Regarding economic trends, today’s retail purchasing managers index of 51.2, a 36-month high, and yesterday’s composite PMI of 54.0, a 35-month high, suggest that real growth in the spring quarter is on track to climb at least 0.5%, or 2.0+% in annualized terms. 

So nothing has happened really dramatically since the April ECB meeting from the currency or regional data to shift the balance of thinking on the Governing Council sufficiently to produce a different outcome that last month.  Understandably, analysts and investors are not really set up for a policy change, and the conservative ECB has no reason to spring a surprise.  Part of the message in April was that prudence warrants an interval of wait and see.  Besides, quite a bit more useful information will be known a month from now, such as 1Q GDP and the ECB staff’s simulations of likely future growth and inflation.  Another reason to keep the central bank’s powder dry is the unpredictable Ukraine crisis, which has potentially negative economic and financial implications for Europe that are more pressing than the implications for North America or East Asia.

Fundamental economic comparisons seem to justify the euro’s firm tone.  For one thing, dollar weakness is not limited to the euro.  Sterling, the Norwegian krone and Swiss franc have also move up, and from 105.4 yen in early January, Japan’s currency has recovered to a 101-handle today.  On the data front,

  • We’ve seen manufacturing and service-sector purchasing manager differentials between the United States and euro area converge somewhat.
  • Even though the U.S. current account deficit has narrowed in absolute and relative terms, Euroland now has a surplus that surpasses 2% of GDP.
  • The 10-year U.S. Treasury-German bund spread has widened from marginally less than 50 basis points a year ago to more than 110 bps now.
  • Diminishing intra-euro areas financial strains continue to recede and can be observed in tighter Ezone government bond spreads.

U.S. politicians have a lot of domestic and foreign issues on their plate.  EUR/USD is not a high priority.  In the longer run, a weaker euro and stronger dollar will be in the interest of more people than the converse, but officials aren’t right now going to give a big push to a turnaround, and there isn’t a critical mass of shifting economic fundamentals to make it so yet.  From experience, I’d say the the biggest factor going for a euro slide in May is that it’s knocking on the door of an important level.  Repeated failure to punch through $1.40 could incentivize market players to test the euro’s downside especially if hostilities in Ukraine escalate sharply further.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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