August 29, 2017 / 1:08 PM / a year ago

Commentary: Euro casts cloud over ECB, but for once the uncertainty is welcome

LONDON (Reuters) - The euro powered above $1.20 for the first time in over two years on Tuesday, sowing doubts over how the European Central Bank might respond at a policy meeting next week. But for once, investors in almost all markets will welcome the increased uncertainty.

A huge specimen of the new 50 Euro banknote is pictured during a news conference at the ECB headquarters in Frankfurt April 4, 2017. REUTERS/Kai Pfaffenbach

Financial market volatility is creeping up as North Korea fires more missiles, Donald Trump’s presidency slips even further into chaos and away from passing any market-boosting reforms, and the traditionally choppy month of September looms.

In that light, any prospect that the ECB will delay the process of winding down its bond purchases - essentially pushing back its return to policy tightening - will be met with a sigh of relief.

With the 19-nation euro zone economy at its strongest in six years, policymakers want to begin the process of reducing their bond buying, thereby gradually removing the huge monetary stimulus that has largely underpinned that very recovery.

The ECB began its asset-purchase scheme in March 2015. It has so far bought around 2.3 trillion euros of bonds. It is expected to begin winding down the programme in early 2018, but inflation and inflation expectations remain well below 2 percent.

The rising exchange rate complicates attempts to “normalize” policy, however. It dampens already weak inflationary pressures as it is effectively a tightening of policy, which lessens the urgency to taper.

According to economists at French investment bank BNP Paribas, a 10 percent rise in the euro corresponds with a fall of nearly 0.5 percentage points in inflation over the next 12 months.

When the ECB last met on July 20, the euro was at $1.15. ECB President Mario Draghi said then that the rising exchange rate had received “some attention” from policymakers.

Tuesday's rise in the euro above $1.20 for the first time since January 2015 means the currency is now up 15 percent against the dollar this year and almost 5 percent on a trade-weighted basis. It is on course for its biggest yearly rise since 2003.

But Draghi made no mention of the euro or of his policy intentions at Jackson Hole last week. Federal Reserve Chair Janet Yellen adopted a similar vow of silence on U.S. policy, which markets interpreted as “dovish”.

The Fed’s apparent caution over raising rates much further and reducing its balance sheet trumped Draghi’s lack of policy steer, pushing U.S. yields and the dollar lower. In some ways, the ECB is powerless to stop the euro’s rise.

Investors, especially equity investors, will hope the higher exchange rate stays the ECB's hand on tapering. According to Deutsche Bank, every 10 percent rise in the trade-weighted euro lowers earnings per share by 5 percent. Full-year 2017 earnings revisions have turned negative this summer.

World stocks are poised to dip in August for the first time in 10 months, the longest winning streak since 2003-04, and the S&P 500 for a 1 percent fall, its worst month since October. But thanks to the euro’s surge, euro zone stocks are looking at a 2 percent fall.

The longer-term risks of central banks keeping the liquidity taps open are evident: asset bubbles form, corporate, household and financial market leverage rises, and low returns force investors out the curve into riskier, less liquid assets and markets.

But in the short term, the rising tide of prolonged liquidity provision is lifting most boats. Credit spreads are tight, emerging market currencies and firming, developed market bonds are rising and stocks are holding up well despite being at historic or even record highs.

No change from the ECB will go a long way to keeping to keeping that picture intact for a while longer.

The views expressed in this article are not those of Reuters News. 

Reporting by Jamie McGeever; Editing by Hugh Lawson

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