Has the ECB run out of options?

To go from a currency that was under threat of complete collapse to one that is outperforming other western currencies, especially when the underlying economic fundamentals do not wholly stack up, is somewhat unnerving.

Add to this the swing from those selling the euro to those buying the single currency over the last week. Hedge funds have increased their bullish euro positions by 36% while decreasing their bearish euro positions by an unprecedented 25%.

The growing divergence between the size of the US Federal Reserve balance sheet and that of the European Central Bank (ECB) has been a key reason to be bullish on the euro. The Fed has kept an extremely loose monetary policy stance since December 2008, resulting in protracted weakness in the dollar against a basket of currencies. The inability of the ECB to embark on similar easing coupled with ECB president Mario Draghi’s assertions that he would do ‘everything it took’ to preserve the euro gave a new lease of life to the burdened currency. Given how important exports are to the eurozone recovery and indeed make up the primary engine for growth in Ireland, a strong euro does not necessarily bode well.

When the euro was trading at $1.37 back in early February, there was a flurry of attempts to talk down this strength. The ECB has continually attempted to undermine the recent speculative bullish tracking of its shrinking balance sheet by introducing the idea of being technically open to negative deposit rates. Initial reaction to what would be an unprecedented event was to sell the euro, resulting in a decline of almost 7% in euro strength before bottoming out at $1.2755 in late March.

Eurozone inflation is not such an immediate concern with the consumer price index remaining at a seasonally adjusted annual rate of 1.4%. This ultimately strengthens the ECB’s hand when it comes to cutting rates on overnight bank reserves. But it would now appear that for all the bluster, market participants either don’t believe that such a move will occur, or they are frankly choosing to ignore it, for now, at least. This is evident by the fact that the euro has retraced over 60% of that sell-off and is currently trading at four-month highs against the US dollar.

The EUR/GBP trade is normally correlated to the EUR/USD direction trading in the same upward bias on a weekly basis, over 70% of the time. The range has been reasonably tight, varying between 0.84p and 0.86p since the middle of March. This positive correlation is helped by continued loose monetary policy from the Bank of England, with interest rates remaining at record lows since March 2009 and but for the decision to up asset purchases by £50 billion in July 2012, we have not seen a change a massive change in tack from the monetary policy committee. Certainly, compared to the eurozone, inflation is high and at 2.7% year-on-year could well present a problem being above the target level of 2%, but especially since UK wage growth is not exactly tracking upwards at the same rate. What lies ahead for UK monetary policy is anyone’s guess, with a new governor in the form of the Bank of Canada’s Mark Carney taking up the position next month.

The euro is currently looking to test the 86p mark once again against the pound, and since we have not seen the pair trade above this level since early March despite several attempts to breach this point, sellers might once again step in. If not, then a move towards the 88p mark in fairly short order is almost inevitable. I would not expect to see the euro trade any lower than the bottom of the recent range around 84p in the coming months unless some significant market-moving central bank decisions are made.

Given that history continues to show us how behind the curve central banks are, we may well be looking at a stronger euro for a while to come. If anything, given the lack of viable tools available to the ECB, any FX movements are likely to be as result of action from other central banks.

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