The euro touched an amazing 2 ½ year high on Thursday after the European Central Bank (ECB) announced that it would not lower their key repo rate at its biweekly monetary policy meeting.
That’s bad news if you are going to Europe this summer, or for U.S. importers. But why is the euro so strong? Well, taking a step back, almost no one had predicted the euro to be so high this year. In fact, at the beginning of the year, 90% of money center bank analysts predicted that 2014 would be a year for the U.S. dollar to strengthen, especially with a stronger U.S. economy and further Fed tapering. There are many arguments, but I believe it’s because real interest rates in the Eurozone are too high. The real interest rate is basically the return on your currency; taking into consideration inflation. And that’s precisely the problem there – there is no inflation, which keeps the real return of the euro high. So, if an investor has a choice of owning a currency that offers higher real returns, they naturally gravitate towards that. In fact, that’s been the trend over the past couple of months where investors have been happy to buy up even the peripheral countries’ securities, such as the Spanish or Italian government bonds. Those inflows into Europe have supported the euro.
The other reason is the slow response by the ECB to counter this disinflationary pressure in the eurozone. While the move by the ECB was widely expected on Thursday, the market feels it cannot come to a clear consensus among its 11 member nations, as there remains strong contrast among the good and bad economies within the EZ. So no action on the nominal interest rate front means that their real return remains attractive for the euro.
My View: The euro will remain resilient until the ECB begins moving on monetary easing. Right after the ECB meeting, President Mario Draghi said that policy makers stand ready to ease monetary policy in June. The market responded with the euro falling by 1% within an hour. However, for the euro to fall further it will require the ECB to take real action.
|This report is for general information and education only and was compiled from data and sources believed to be reliable. City National Bank does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors as of the date of the report with no obligation to update or notify of inaccuracy or change. This report is not a recommendation or an offer or solicitation to buy or sell any financial instrument discussed. It is not specific investment advice. Financial instruments discussed may not be suitable for the reader. Readers must make an independent investment decisions based on their own investment objectives and financial situations. Prices and financial instruments discussed are subject to change without notice. Instruments denominated in a foreign currency are subject to exchange rate and other risks. The Bank (and its clients or associated persons) may engage in transactions inconsistent with this report and may buy from or sell to clients or others the financial instruments discussed on a principal basis. Past performance is not an indication of future results. This report may not be reproduced, distributed or further published by any person without the written consent of City National Bank. Please cite source when quoting.|