Thursday, February 7, 2013

The ECB staying out of currency wars - for now

Once again some analysts in Europe question the potency of the so-called currency wars launched by Japan and the US. The euro-yen currency cross has had an unprecedented rally, changing the export landscape where Japan and Europe (particularly Germany) compete.

Yen per one euro (EUR/JPY)

The impact of this adjustment in currencies is quite visible in the shares of exporters. The chart below compares share prices of Volkswagen and Toyota - as an example. It demonstrates once again how effective currency wars can be (see discussion). Weak yen is making Japan's products cheaper and/or margins higher.

Toyota (blue) vs. Volkswagen (red)

This trend is likely to negatively impact the Eurozone's economy, which, for the first time since the start of the euro crisis, is starting to show signs of recovery (see post). The question now is whether the ECB is going to "retaliate" in the currency war by attempting to weaken the euro.
Bloomberg: - Since the European Central Bank president talked up the economic outlook last month and signaled that the worst of the debt crisis is over, the euro has surged to a 14-month high against the dollar. Banks have fueled the euro’s rally by paying back more emergency loans than forecast, shrinking the ECB’s balance sheet just as the Federal Reserve and the Bank of Japan expand theirs.

That’s threatening to stymie Europe’s recovery before it has begun, highlighting the tightrope Draghi is walking as he seeks to boost confidence without encouraging euphoria. With looser monetary policy in the U.S. and Japan weakening the dollar and the yen, the ECB may soon come under pressure to enter the so-called “currency war” and rein in the euro, economists said.

The euro-zone economy needs a rising euro like it needs a hole in the head,” said Nick Kounis, head of macro research at ABN Amro in Amsterdam. “If verbal intervention does not stem the euro’s upward trend, the central bank may eventually once again consider rate cuts.”
So far however the ECB has stayed away from direct asset purchases.
Bloomberg: - “A significant shift is underway in global central banking,” said Paul Mortimer-Lee, global head of market economics at BNP Paribas SA in London. “There is a worldwide currency war and the ECB seems to be a central bank that is not targeting the real economy as much as the Fed, the Bank of Japan and the Bank of England,” he said. The ECB “risks being the loser.”
It is expected that Draghi will retain a highly dovish stance (as he announced today) with respect to the ECB's policy but will not explicitly target a lower euro.
Barclays: - ... Draghi may adopt a more dovish tone to convince market participants that monetary conditions will remain loose, but we view any specific ‘talking down’ of the EUR as unlikely. Based on the check-list of indicators from the ECB’s January press conference (CDS prices, stock market indices, realised volatility, capital inflows, Target 2 imbalances, confidence indices, current account balances), market developments are likely to be viewed as broadly positive by the ECB more than offsetting any negative impact from EUR strength. 
What makes Draghi's situation particularly difficult is the fact that the Eurozone banks have been repaying some MRO and LTRO loans. That is resulting in declines in the EMU's monetary base (as bank excess reserves drop). At the same time the monetary base has been on the rise in Japan, the US, and the UK. This differential in base money growth (h/t Evil Speculator) continues to pressure the euro higher (although we are seeing a bit of a reversal today). And European politicians as well as some bureaucrats are beginning to argue that something should be done. For now, however, it is expected that the Eurozone will have to tolerate the relative euro strength, as the ECB stays out of the currency wars.

Source: ECB

Econoday (today's ECB announcement): - Perhaps more significantly, Drahi's opening remarks made no mention of the exchange rate despite some speculation that the central bank might have become concerned by the euro's recent appreciation. However, in response to questioning, he commented that current levels of both the nominal and real effective exchange rates are close to their long-run averages. This may not be what the ECB would prefer given the weakness of Eurozone domestic demand, but it also suggests that for now at least, the level of the single currency is not a major factor in setting monetary policy. In turn, this may be seen by speculators as a green flag to take the euro still higher.
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