Despite the euro having risen against the US dollar in the first part of this year, the European Central Bank (ECB) has kept quiet about its ascent. In addition, various European politicians have also not complained about a stronger euro and the possible damage a stronger currency may cause.
It is generally assumed that the reason for the silence is twofold. Firstly, the higher euro was bringing much needed disinflationary pressure and hence the ECB's silence, and secondly the G7 statement from a political angle gave the impression that there was a tacit understanding that the euro had to play its part in a potential global rebalancing. So from a political angle as long as the euro was rising in conjunction with other currencies then its move against the US dollar would be seen as acceptable.
The rise in the price of oil has been more aggressive in US dollar terms than in euros this year. However, the difference is marginal in the context of the large rise in the oil price since 2003. Although a stronger euro helps mitigate the rise in the oil price, it cannot stop the overall upward trend. Looking at the rise in the euro-dollar after the G7 meeting, it transpired the euro actually fell against some of the other currencies.
Looking at the euro and its ascent from the date of the G7 meeting last April up until the beginning of June when the US Federal Reserve chairman, Ben Bernanke, gave a hawkish speech, the trade-weighted euro hardly rose at all. HSBC research is of the opinion that it is instructive to segment the euro move into two different periods: Phase I - the post-G7 move/the structural US dollar sell off; and then Phase II - the US dollar recovery through concerns about higher US interest rates.
Another factor that is to be taken into consideration is that in the ECB's view the UK is a more important trading partner for the euro area than the US. The point of this observation is to highlight that ECB thinking about the euro is not solely focused on the price action of euro-dollar but also takes into account euro-GBP and to a lesser extent the euro versus peripheral foreign exchange. Therefore, if euro-dollar is rising quickly while euro-GBP is falling at the same time, the ECB may feel more at ease about broad euro appreciation.
This view also suggests that if the euro is strengthening rapidly versus the US dollar and sterling, the ECB might be more worried that the pace of euro appreciation would be happening too quickly. This raises an important point because while there was so much market focus on the euro-dollar in May, the ECB appeared relatively relaxed about it.
The risk now for the ECB is if the euro starts to appreciate more broadly, especially if positive euro-GBP drivers gather momentum. Indeed, this is a feasible scenario. However, the ECB cited a stable euro-GBP as a reason not to be concerned about euro-dollar strength. There is not much confidence in the view that the euro-GBP exchange rate could stay in a comfortable zone and not trigger a more material rise in the euro. Taking stock of key euro-GBP drivers suggest the risks increasingly point to the upside.
Three factors have been identified that could see euro-GBP press higher. The first is the lack of M&A inflows to the UK from the euro area. The second is the fact that the Bank of England remains a laggard in the interest rate cycle and the third is that the Bank of England still wants to re-balance the UK economy away from consumption and more towards exports, effectively requiring a weaker GBP as part of the recipe. However, an export recovery via a weaker sterling would be played out more versus euro than the US dollar.
One of the factors that has downgraded sterling's prospects has been a lack of M&A inflows. This is not to say that the M&A flow is directly euro-GBP positive but more of an indication that the balance of the bigger picture FDI flow has turned in favour of euro versus sterling. The perception of sterling benefiting from M&A traffic has waned considerably.
Another key reason that argues for further euro-GBP upside is the fact that the pair's relationship to relative yields remains dynamic. Given the ECB will continue to raise interest rates this year while the expectation is for the Bank of England to remain on hold, the narrowing interest rate differential has already chipped away at downward pressure on euro-GBP. If the ECB continues to raise interest rates while the Bank of England keeps a steady hand, the interest rates market would have to price out expected rate hikes from the UK. If this occurred, the interest rate differential should put upward pressure on euro-GBP.
The main point being stressed is that although many monitor the euro-dollar as the bell weather to the prospects for the euro, this is not the case for the ECB and other officials. HSBC Research opines that if one holds a long euro-dollar position without watching the euro in broader terms, one may miss out on an important part of the reaction function of the ECB.
As a result the euro-sterling looks like it has upward traction, the Central Eastern European currencies are struggling, and the euro-dollar may be heading north. This may elicit a very different reaction from policymakers and the ECB.
This report was compiled by Peter Calleya, manager, Corporate Strategy & Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.