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Why Soaring Euro Is Causing Concern For The European Central Bank - Citi UK

3 October 2017FXEconomicsEurope
Soaring Euro Concerns for ECB - Market Insights - Citi UK

Why the soaring euro is causing concern for the European Central Bank

By Citi Analysts

  • The euro has risen 13% against the US Dollar in 2017
  • The rise of the euro has the European Central Bank (ECB) concerned
  • Low inflation rates will likely see the ECB taper spending to manage risk

The rise of the euro against the US dollar has accelerated over the summer. In fact, when European Central Bank (ECB) president Mario Draghi announced earlier in September 2017 that a drastic change in quantitative easing spending was unlikely, the currency still climbed to a two and a half year high. But while this strong performance sounds like a big positive for the eurozone, the ECB continue to voice concern about this rapid rise.

Citi analysts believe that's because the exchange rate of the euro is currently rising at a rate which doesn't correlate with actual economic growth. As such, some of the tactics which have been used to boost the economy as of late will need to be curbed in order to bring the euro back to optimum inflation levels. The weakness of the euro benefits the exporting countries and has helped foster the economic recovery.

Why is the euro currently so strong?

The euro has been strengthening as the market is pre-empting the normalisation of monetary policy; at current the ECB has a quantitative easing programme of €60bn, and interest rates of minus 40bps (basis point). The expectation that Mario Draghi will announce the gradual normalisation of policy, thus removing the stimulus, has led to the euro strengthening from the lows seen at the start of 2017 (EURUSD 1.0342).

Citi analysts also believe the uncertain political climate in the US has been another boost to the euro, which has benefitted from the USD's steady decline. The US dollar had begun 2017 benefiting from the "Trump-trade"; the expectation that fiscal stimulus from infrastructure spending and tax reform in the US would benefit the USD. However, this has yet to materialise, with Trump only recently announcing the eagerly anticipated US tax reform.

Despite the gradual impact of these longer term situations, more volatile events are unlikely to make the same lasting differences. While the USD's value may currently be affected by political tensions in North Korea, a Citigold study shows that the impact of similar political incidents on the economy is generally limited to the short term – typically a brief dip before a recovery soon afterwards.

Why is this considered bad?

Should the euro continue to rise, it could also be bad news for economic activity. The higher the euro, the more expensive it becomes for outside countries to trade, and a drop in exports would weaken growth, thus slowing the recovery

What happens next?

Because of these concerns, any move by the ECB will be a gradual process over the long term. Belts will likely start to tighten to avoid lowering inflation any further, which means a probable tapering of monthly quantitative easing spending. However, the ECB will likely want to retain as much flexibility as possible into the New Year.

Citi analysts expect that Inflation forecasts for 2018 and 2019 will be cut, but future plans are still to be clarified in October. Some asset purchases would still need to continue to avoid any drastic drop in inflation rates, and that should offer some comfort to traders importing to the UK.

Despite these concerns, our analysts remain cautiously optimistic about European equities. An improving earnings outlook and good dividend yield are both positives for the currency, which maintains an attractive valuation relative to the USD.

Read more about optimising your portfolio to minimise risk in uncertain climates, and remember that your Relationship Manager is always on hand to discuss any concerns.

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