The surge of the euro during January was mostly driven by optimism about the debt crisis: there is a general notion that the worst is behind us. Bond yields of Spain and Italy fell and the need for a bailout including the “Men in Black” has eased as well.
Mario Draghi is seen as the hero: his London speech in July 26th, where he said he will do “everything to preserve the euro, and believe me, it will be enough” is the turning points. Draghi then followed through with the OMT, which proved to be a big bazooka – it wasn’t used so far.
* This article is part of the February 2013 monthly forex report. You can download the full report by joining the newsletter in the form below.
And the specific boost for the euro in January came from Draghi once again: he pat on his back and while saying “the jury is still out”, he noted the change in the financial markets and expected to see “positive contagion” from the financial markets to real economy, in the second part of 2013.
Money that left the euro-zone during the worst days is now flowing in once again, pushing the euro higher; in a manner that is worrying many officials: a higher exchange rate makes exports less competitive.
The positive atmosphere can already be seen in forward expectations: German business confidence looking better and also purchasing managers’ indices for January look better than earlier.
Real economy suffering, also from the exchange rate
However, the real economy is still struggling: the recession most likely continued in Q4: we will get full data during February. The economic contraction includes the biggest locomotive, Germany. Spain’s unemployment rate reached 26% and Greece is not out of the woods.
As aforementioned, the higher exchange rate certainly weighs on prospects of growth. The ECB is not expected to intervene in the currency wars: this is not in its cook book. Politicians will likely complain, and make their complains loudest during the G-20 meetings in Moscow.
EUR/USD at the round number of 1.40 could not raise political noise but also trigger a significant pullback. The damage to the economies would loom heavily and could outweigh other forces that are battling in currency wars: the Fed with QE4 and Japan with its very determined deflation fighting policy, to name a few.
What Draghi can do is lower the interest rates: the recent fall of inflation to 2%, exactly the ECB’s target will ease opposition from the Bundesbank. In addition, the ECB’s own prospects point to a drop in inflation later in the year. A lower interest rate could help the struggling economies by making lending cheaper, as well as contribute to a lower interest rate.
After the ECB made a sharp turn from discussing a rate cut in December to a unanimous decision to keep rates unchanged in January, we cannot expect another U-turn in February. However, this cannot be ruled out during the spring.
Update: Draghi Warns About Exchange Rate – EUR/USD Free Falls