July 21, 2017 / 10:35 AM / 2 months ago

Euro rally will only speed its own reversal

The euro sign landmark is seen at the headquarters (R) of the European Central Bank in Frankfurt September 2, 2013. REUTERS/Kai Pfaffenbach

LONDON (Reuters Breakingviews) - Traders push the euro up at their own peril. The single currency’s recent broad-based strength risks depressing import prices when inflation is still too low. Any hint that a stronger exchange rate could prompt European Central Bank President Mario Draghi to leave monetary policy loose for longer will force the euro back down again.

The currency rose above $1.1670 for the first time in two years on Friday, extending gains triggered by Draghi’s press conference a day earlier. The reaction is odd, as the ECB chief said the central bank would be patient and prudent rather than rushing to scale back its bond-buying programme. Textbooks suggest loose monetary policy should boost fixed income securities but weaken the currency. Though euro zone bonds duly rallied, currency traders took a different view.

One explanation is that foreign exchange markets took comfort from Draghi’s upbeat comments about the economy and his lack of any explicit concern about the euro’s recent gains. The single currency has risen by 5 percent against a trade-weighted basket of currencies since February and twice as much against the U.S. dollar. Asked about those moves, Draghi said only that the repricing of the exchange rate had “received some attention”.

However, Draghi also said that the last thing the ECB wants is any tightening of financial conditions that might choke off the euro zone’s economic recovery. The rule of thumb is that a 10 percent rise in the euro’s trade-weighted value eventually shaves between 0.4 and 0.5 percentage points off the inflation rate. That’s not what the ECB needs: prices rose just 1.3 percent in June compared with a year earlier, still well below the central bank’s target of just under 2 percent. The more the euro strengthens, the greater the risk that the rally brings about its own reversal.

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