In response to a stronger euro, the European Central Bank yesterday cut its inflation forecasts—price gains of 1.2% and 1.5% are now expected in 2018 and 2019, respectively, down from 1.3% and 1.6%. Since the ECB’s monetary policy mandate is entirely focused on consumer prices, the disinflationary impact of a stronger currency leaves policymakers with a conundrum: do they go ahead and taper asset purchases as expected, or instead hold back, figuring that the currency markets are doing the “tightening” job for them? I for one am not counting on such double-think delaying the inevitable wind-back of quantitative easing.
Since 2012, the eurozone current account has moved from being in balance to a surplus of about 3% of GDP, or EUR370bn. This stemmed from austerity which hit domestic demand, and later easy monetary policy which weakened the euro. As a result, the euro became a “risk-off” currency—in normal periods money flowed out in search of higher yields, only to return after an external shock (see Despite Draghi, Flows Favor The Euro).
Since March, euro strength has been driven less by risk-off urges than rising confidence in Europe’s recovery. GDP growth in the single currency area for 2Q17 was yesterday revised up to 2.3% YoY, the best reading since early 2011. With soft data continuing to improve—the eurozone manufacturing PMI hit a post-2011 high in August—there is reason to think the euro will remain on an uptrend, even if a correction is overdue.
During its crisis phase, the eurozone can be thought of as exporting deflation. Very tight financial conditions in southern Europe caused a collapse in consumer spending and investment. That cycle has reversed, with renewed confidence causing employment growth and fresh capital spending. Aided by a stronger euro, eurozone imports will accelerate, which will apply a certain degree of upward pressure to global prices.
Rather than fret about the euro’s level, investors should pay attention to real rates since the ECB has signaled that it wants to keep a neutral stance as the recovery hardens (see Making Sense Of Mario Draghi). Real rates remain at very low levels and have actually ticked down recently as CPI has edged higher and the yield curve has flattened, with interest rates along the curve moving lower. At such levels, rates remain very supportive for the economy and offset the impact of euro strength.
Investors should therefore prepare for a small reduction of ECB asset purchases from January next year. The recent poor performance by banks provides an opportunity to build positions in a sector that should benefit most from the tapering as the change will boost net-interest margins, leading to an acceleration in bank lending.
This article originally appeared at Gavekal Research.