19th Jan 2021

Will the ECB try to Curb Strength of Euro

Article Table of Contents:

Resurgence of covid-19, renewed restrictions, declining inflation, and a slowdown in economic recovery. If this was not enough, the European Central Bank (ECB) now has a new concern - the euro strengthening against the US dollar. The EUR/USD pair gained 12% in five months since the start of the pandemic-led lockdowns in 2020. By the end of August, the pair had breached the 1.20 mark for the first time in two years. While this may be a matter of pride for the region and a delight for those going long on the pair in FX exchange trading, a surging currency has an adverse impact on the European countries that rely on exports. A strong euro lowers the price competitiveness of exports from the European region and has a dampening effect on inflation, as imports become cheaper.

For an economy already facing extremely low inflation levels and recessionary pressures, a strong euro is a meaningful drag, something which the ECB is concerned about.

Declining US Dollar Adds to the Woes

Those involved in FX exchange trading need to understand that currency pairs are impacted by both the base currency and the quote currency. Therefore, a weakening US dollar also boosted the EUR/USD. The greenback declined by almost 7% in 2020 as the US Federal Reserve continued to cut interest rates and injected money into the economy. These dynamics could weigh on the US dollar in 2021 as well. The US central bank has indicated that it will focus on the employment rate, rather than on inflation, which necessitates keeping interest rates at record low levels for a few years.

Moreover, rapid vaccine rollouts have begun in the US and Europe, supporting expectations of a recovery in their economies. While such prospects support the euro, they have the opposite impact on the US dollar. The greenback, which is considered a safe-haven asset, could lose its lustre if investor risk appetite improves.

The ECB Stance

The ECB minutes of meeting released in December last year highlighted the central bank’s concerns around low inflation and euro appreciation in the global FX exchange market.

The ECB extended the pandemic emergency purchase program (PEPP) till March 2022 and increased the proposed funding by €500 million. The injection of money into the economy means increased supply of the currency, which typically lowers the currency’s value. However, additional stimulus failed to dampen the euro, which continued to trade above 1.20 against the greenback on January 20, 2021. This level was considered a cautionary red line in the past. Does the European Central Bank have any policies up its sleeves to bring down this value?

Will the ECB Become More Accommodative?

So far, the FX exchange market has exhibited little correlation between European monetary policy and the euro’s exchange rate. With the increase and extension of its accommodative monetary policy, the ECB has limited wiggle room remaining to control the strength in the EUR/USD pair. However, much is dependent on the spread of the virus, which is increasing in countries like Germany. Further restrictions and lockdowns, the pace of vaccine rollouts, and the disbursal of stimulus by the EU and, more importantly, by the US, will guide the European Central Bank’s policy in the coming months.

Vaccination efforts in particular could lead to medium-term investor optimism and no policy changes in the first quarter of 2021.

If the euro continues to strengthen rapidly or there is sudden inflation, the ECB may be forced to take action. For now, it is a wait and watch approach, both for the central bank and traders.

Will risk-on trades take the EUR/USD higher? Will the pair retrace below the $1.20 mark anytime soon? Do you think ECB President Christine Lagarde is as concerned about the euro as her predecessor? Tweet us@gt_io_Global and let us know your thoughts.
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