How Much EUR Weakness Will ECB Tolerate?

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We know that central banks have a problem with strong currencies but the question that we face today is the amount of issues that a weak currency poses for the European Central Bank. The ECB’s decision to cut interest rates to a record low of 0.75% last week drove the euro to a 2 year low against the U.S. dollar, a 3 year low against the British pound and a record low against the Australian dollar. While the milestone reached in the EUR/USD may not seen significant compared to other currencies, it is when we consider that the currency pair is only 3% away from its 6 year low and only 5% away from its 8 year low. Central banks usually do not like a weak currency for 3 reasons – it pushes prices or inflation higher, reflects underperformance of the economy and reduces the purchasing power of local citizens who may voice their frustrations publicly. However in an environment of slowing global growth, a weak currency is not only tolerated but could be a part of the strategic plan by a central bank to stimulate their economy.

For the ECB, the fact that the EUR/USD has fallen to a 2 year low is nothing but good news. As an inflation targeting central bank, the ECB should be concerned about an overly weak currency but with soft domestic demand and the prospect of even slower growth ahead, inflation is predicted to trend lower. At least week’s press conference, ECB President Draghi said that inflation could fall below their 2% target before the end of the year. This means that a weak euro poses no immediate problems for the ECB and will in fact help in the central bank’s efforts to stimulate their economy. With domestic demand threatened by austerity, a falling currency will help to boost export and tourism industries. For our friends in Australia, there’s been no better time to travel to Europe. In other words, while the ECB will never admit it publicly, if inflation is not a problem, they will welcome a weak currency.

Historically Speaking, the Euro Isn’t that Cheap!

Also, the euro is not extremely cheap on a historical basis. Over the past 10 years, the EUR/USD has averaged around 1.2850, which means that it is only 4.5 percent below its 10-year average. If we expand this period to include the launch of the euro, the currency is still trading above its lifetime average of 1.21. Also on the basis of purchasing power parity, the euro is still overvalued against the U.S. dollar. For these reasons, the ECB won’t feel any pressure to stop the euro from falling. In fact, we don’t expect the ECB to bat an eye at the euro’s weakness until the EUR/USD falls below its 2005 low of 1.1640.

The ECB has only intervened a handful of times in the past and 3 of those occasions happened after the launch of the euro. Skepticism about the “euro project’s” viability drove the EUR/USD to a record low of 0.8230 in October 2000. At the time, the central bank fought hard to show their commitment to the currency and with the help of other central banks, they were eventually successful. The ECB also intervened in March 2011 after Japan’s earthquake but that was a unique situation where they bought euros and sold yen. Their intervention in 2000 was about pride and in 2011 it was about empathy. Today, the ECB’s top priority not pride or empathy but growth and they need any help they can get to pull themselves of recession – including a weak currency. It would be a mistake to expect the ECB to intervene in the foreign exchange market and stop the EUR/USD from falling even if it breaks 1.20. In fact, they have and will continue do everything in power to keep the euro weak until the Eurozone economy turns around.

Kathy Lien
Managing Director

3 thoughts on “How Much EUR Weakness Will ECB Tolerate?”

  1. While I agree on all of these, I believe we shouldn’t leave US out of this. After all it IS a currency war. These beggar thy neighbour policies will only work if your neighbours do not devalue their currencies. I truly doubt Bernanke will stay put, after all isn’t his goals and environment very much the same as the ECB? the only difference is the spotlight is now more on EU than on the US.

  2. Thanks Kathy, absolutely agree. I believe that the USD still has a lot of room to continue strengthening, and currency wars are not the focus of countries right now especially for the US. Take a look at the recent developments. The FOMC minutes, for example, Bernake and the Committee have no particular rush to weaken the USD with Q.E.3 from now until probably September of this year. Notice also that Japan refrained from easing any further and kept interest rates status quo despite the worsening economic conditions in Japan. I believe that there is a concerted effort in weakening the EURO amongst the G7 by naturally using market forces to alleviate the pain of an expensive Euro.

  3. Thanks Kathy, how is the EUR weakness affecting the Swiss Franc, as we see that the EUR/CHF peg of 1.2 is pushing the USD/CHF to parity?

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