August 31, 2017 / 1:43 PM / in a year

COLUMN-Despite FX surge, euro zone financial conditions still remarkably loose: McGeever

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Jamie McGeever

LONDON, Aug 31 (Reuters) - The euro may be the best performing major currency in the world this year, yet financial conditions in the euro zone remain extremely loose.

Stock markets are high, bond yields and interest rates are low (in some cases, negative), credit spreads are tight and credit growth is strong thanks in large part to hundreds of billions of euros of bond-buying stimulus from the European Central Bank.

All told, financial conditions are close to the easiest they’ve been since the euro’s launch in 1999 and aren’t that much looser than in the United States, where the Federal Reserve is raising rates and no longer expanding its balance sheet.

The strength of the euro is likely to be discussed at the ECB’s policy meeting next week and will no doubt be among the main talking points at President Mario Draghi’s news conference afterwards.

Reuters reported on Thursday that its rapid rise is beginning to worry a growing number of ECB policymakers, which could mean the ECB’s asset purchases will be phased out more slowly than initially planned.

“The exchange rate has become a bigger issue,” a source told Reuters. “It is now less favourable for an exit and a stronger argument for a muddle-through option.”

The euro has risen 10 percent against both the dollar and sterling in barely three months, breaking above $1.20 this week for the first time in nearly three years. In years gone by, appreciation on this scale would imperil growth and threaten the ECB’s inflation goals. EURGBP=>

This time, however, it may be different. The following charts from BNP Paribas measure the degree to which the tightening effect of the stronger euro is being offset by other factors.

Not only are broader monetary conditions extremely loose, the euro’s wider trade-weighted value hasn’t risen as dramatically. It is up a much more modest 5 percent this year .

The currency’s strength is also a reflection of how well the euro zone economy is doing. The 19-nation bloc is expanding at its fastest pace in six years and this week analysts at Moody’s became the latest to raise their growth forecasts even higher.

Euro zone growth has traditionally been export-led, and therefore extremely sensitive to exchange rate fluctuations. But growth is now being driven more by domestic demand, making it less sensitive to a stronger euro than in the past.

Of the euro zone’s 1.8 percent annual growth rate in the first quarter this year, domestic demand contributed 2.2 percent and net trade -0.4 percent. In the same period three years ago, domestic demand accounted for 0.9 percent of the overall 1.3 percent growth, according to BNP Paribas.

How do euro zone conditions compare with U.S. conditions? Reasonably favourably, even though the Fed is slowly raising rates and poised to start shrinking its balance sheet.

Soaring equities, sliding Treasury yields and a weaker dollar have more than offset the Fed’s actions, and U.S. financial conditions have eased this year. And still, they’re not much tighter than they are in the euro zone.

As long as monetary conditions on both sides of the Atlantic are loose, investor sentiment, risk appetite and asset markets around the world look likely to remain well supported.

Reporting by Jamie McGeever Editing by Jeremy Gaunt

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