EURUSD has traded in a $1.30-$1.35 range since the start of April, but Steve Englander, head of currency strategy at Citi, says that could change if the central bank does not take action to address rising concerns over the fiscal and economic problems in the region. Englander says the conventional view is that a rate cut from the ECB would weaken the euro, just as speculation about additional stimulus measures hit the dollar recently.
“As straightforward as this view is, it is probably not correct,” he says. “The recent euro weakness reflects stresses on sovereign debt, exacerbated by economic weakness.
“FX market concerns are that Spain and Italy will enter into a downward economic and financial spiral, not that the ECB will be excessively expansive in its policies.”
Englander does not believe a rate cut will support the euro, given that it is an ineffective policy measure to address the region’s problems.
That is because the monetary tightness in the eurozone is not at the short end of the curve, but at the long end, he says.
Indeed, the GDP-weighted eurozone 10-year yield – excluding Portugal, Ireland and Greece – stands 150 basis points above those in the US and other G10 nations. Using the Fed’s rule of thumb that 150bp at the long end of the curve is equivalent to 600 to 800bp of short-end tightness, a 25bp cut is, therefore, a drop in the ocean.
“If the ECB surprises with a policy rate cut, the euro may fall anyway because FX investors will see it as an ineffective policy move, unless they imply very strongly that this is a first installment on more aggressive policy moves down the road at the long end,” says Englander.
Similarly, hints at another three-year long-term refinancing operation are unlikely to give the euro long-term support, given the limited positive effect on the currency of the last two.
Englander believes only the announcement of a resumption of ECB government bond buying through the Securities Markets Programme (SMP) would provoke a strong euro rally.
He believes that is unlikely, however, given that a resumption of the SMP would be highly controversial among the central bank’s governing council.
“The euro will react badly to the absence of effective policy relief,” says Englander.
“We are not nearly as negative as most of the market on the euro over the medium- and long-term. However, the absence of policy support in a somewhat negative global risk environment, with deteriorating eurozone financial economic conditions, could provoke a sharp, immediate, downward move in the single currency.”