Further euro strength could prompt ECB rate cut
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Foreign Exchange

Further euro strength could prompt ECB rate cut

The prospect of official reaction to the recent strength in the euro is likely to keep its gains in check ahead of this week’s European Central Bank (ECB) meeting.

A tightening in eurozone rates combined with the perceived willingness of eurozone policymakers to tolerate strength in the euro have been the driving forces that saw the single currency surge in January to its highest level on a trade-weighted basis in 14 months.

It is widely thought that eurozone policymakers are less likely to lean against strength in the currencythan other policymakers across the globe. That in part is because strength in the single currency reflects faith in the concept of EMU, something the ECB has been battling to preserve during the region’s debt crisis.

Alan Ruskin, FX strategist at Deutsche Bank, says it is unlikely the recent move higher in eurozone rates and the euro are considered desirableat the ECB.

“The problem the ECB faces is they are perceived to be the only central bank that is fully keeping to the spirit of the G7 non-interventionist script,” he says.

Still, after the recent move higher in the euro, investors will be wary ahead of the meeting.

Valentin Marinov, FX strategist at Citi, however, believes the strength of euro – and the pace of the single currency’s recent appreciation – is not yet at levels that will prompt a response from the ECB.

He thinks Mario Draghi, ECB president, will reiterate the mantra that FX markets should not be driven by official intervention after this week’s meeting.

Indeed, Marinov says it unlikely Draghi will want to respond to the recent appreciation of the euro ahead of the G20 meeting of finance ministers and central bankers, which starts in Moscow on February 14. Many see that meeting as a chance for global policymakers to air their concerns over increasing currency frictions and in particular Japan’s campaign to talk down the yen.

“This could add to the tailwinds for the single currency in an environment of intensifying currency wars,” says Marinov.

However, he warns that further sharp gains could provoke a rate cut from the central bank.

Citi uses a regression model that predicts ECB rate cuts using lagged moves in the trade-weighted value of the euro, as well as macro determinants such as business sentiment and bank liquidity.

As can be seen from the chart below, the model has performed well in predicting rate cuts.

 ECB main refinancing rate and probability of a cut
 Source: CitiFX, BoE, Bloomberg 

A simulation of the model shows that if the euro revisits its 2011 trade-weighted highs during the next month – which would represent a further 5% rise after the 4% appreciation seen in January – it would push up the model probability estimate for a cut close to levels that preceded easing from the ECB in the past.

When the euro hit its trade-weighted highs in 2011, EURUSD was close to $1.50, compared with around $1.37 today.

Marinov adds a caveat, however, saying the historic relationships captured by the model might be underestimating the ECB’s sensitivity to further euro appreciation.

That is because, with fiscal austerity measures likely to continue to weigh on domestic demand and unemployment rampant in the eurozone, exports to the rest of the world are likely to be a larger driver of the region’s recovery than in the past.

“ECB officials are aware that the eurozone economy is in a worse shape than in 2011,” says Marinov. “In turn, euro appreciation could trigger a response before EURUSD revisits past highs.”

This week’s ECB meeting might well provide euro bulls with some encouragement, but investors should not discount official action entirely if the single currency’s sharp gains persist.

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