Weakening the Euro, Easier Said Than Done

4/6/2014

By Alen Mattich

The market rule of thumb says that falling interest rates ought to result in a weakening currency.

The exact opposite has happened in the euro zone during the past year. Which raises the question of whether any measures the European Central Bank imposes at Thursday’s meeting will manage to depreciate the euro substantially for very long. Short, that is, of active intervention in the currency markets, which isn’t on the cards.

Since the summer of 2012, when ECB President Mario Draghi promised to do “whatever it takes” to save the euro, market interest rates and especially sovereign debt yields have tumbled across the single currency region. But over the same period, the euro has appreciated.

What is likely to have happened is that a substantial premium had been built into market rates against the risk of the euro falling apart. As that risk was removed, the premium attracted big volumes of investment. When the money came from outside of the euro zone it pushed up the value of the euro.

But surely there’s a limit to these flows?

After all, how much lower can sovereign debt yields get in the euro zone? Spanish and Italian 10-year bonds now yield less than half a percentage point more than U.S. Treasury bonds compared with nearly six percentage points in the case of Spain at the worst of the crisis. And German 10-year bonds pay some 1.1 percentage points less than their American equivalents.

It could be that this yield compression has run its course. But on inflation-adjusted terms, European bonds still offer a premium to U.S. bonds–euro-zone inflation is running at an annual rate of just 0.5%, and in some member states it’s even negative, whereas in the U.S. the latest inflation rate was 2.0%. So it could be that people keep pouring money into the euro zone for now.

The euro has further been boosted by turbulence in emerging markets, not least Russia. Ironically, the U.S. Federal Reserve’s moves to tighten policy could end up supporting the euro if it increases instability in emerging markets and prompts another round of safe haven seeking into the euro zone.

And then there’s the matter of Europe’s substantial current account surplus with the rest of the world–much of it actually Germany’s surplus. A strong current account position tends to be supportive of the currency.

Trimming interest rates marginally from where they are now and even launching a probably no more than modest round of asset purchases, or quantitative easing, is unlikely to cause a big further slide in the euro. Indeed, a fair bit seems to be priced into the exchange rate, so the euro could end up appreciating on the news, especially if it’s less dramatic than expected.

What could the ECB do instead? Well, it could intervene in the currency markets, actively selling the euro and buying other currencies or even non-euro zone sovereign debt. But this seems unlikely, not least because it would run the risk of back-firing and trigger a round of competitive devaluations with other central banks.

Whatever it does do, what seems clear is that the ECB will soon find itself running out of options.

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