What the latest change in tack from the European Central Bank, amid drumbeats of verbal intervention and yet more disappointing inflation data, might mean for currency markets.
In the last few years, we’ve seen that one of the most consistently poorly performing investment strategies has been following currency momentum. The kind of sustained, multi-year currency trends that characterised the 1990s and 2000s have become a thing of the past as central banks deploy verbal (and the threat of actual) intervention to manage exchange rates within relatively narrow corridors.
That change in landscape has become so extreme that we have seen anti-momentum currency trades start to become consistent winners. The post-COVID-19 currency markets have been dominated by a lurch lower in the US dollar that threatened to break that pattern: on a broad trade-weighted basis (at the time of writing), the dollar index is down around 10% since its March highs, with the Federal Reserve’s framework review providing the latest catalyst.
Last week brought the first serious pushback against that trend from the European Central Bank (ECB). Philip Lane, the ECB’s Chief Economist, told us that the “euro-dollar rate does matter”. Sternly worded stuff, indeed! More revealing, a number of his colleagues on the Governing Council, under the veil of anonymity provided by an FT article, followed up with even stronger comments: the strengthening of the euro is a “growing concern” and “worrisome”. These kind of comments hark back to the days when Jean-Claude Trichet used to bemoan “brutal” FX moves.
The moment for action
The market seems to have taken this as an indication that 1.20 is some sort of line-in-the-sand for the single currency versus the greenback. For that to be effective, the ECB will soon need to back up words with action.
Policymakers are obviously heavily constrained in their ability to cut interest rates further, but we anticipate an extension of the quantitative easing programme to be announced in the next few months. That won’t be a big surprise to the market, but should help to keep a lid on government funding costs in the peripheral European countries and tame the recent burst of euro strength.
The urgency of addressing this situation will have been underlined by some exceptionally weak European inflation data last week. European headline inflation dropped back below zero for the first time since 2016. On a core basis, HICP inflation* dropped to the lowest level on record at just 0.4%. Such exceptional circumstances are associated with the timing of summer sales, but these are the kind of numbers that will bring an inflation-targeting central banker out in a cold sweat.
With the ECB looking dangerously like Old Mother Hubbard (with a bare policy cupboard) we continue to favour staying short European inflation as a strategy that, in our view, is likely to benefit from a consistent fundamental tailwind.
*HICP – Harmonised Index of Consumer Price Inflation