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Lagarde needs to place a lid on the Euro

If there is a time for a currency to be relatively weak, it's during recessionary periods. A stronger currency entails a rougher time for goods and services to be exported out of the country as those exports are more expensive due to the stronger currency.

This is currently the case for the Euro. From August last year to the latter part of 2020, the EUR/USD fluctuated between 1.16 and 1.19 before shooting past 1.20 at the end of November due to vaccine positivity.

It sits comfortably above 1.20, consolidating between 1.205 and 1.233. Christine Lagarde, President of the European Central Bank (ECB), has a dilemma on her hands: how to contain the strength of the Euro due to positive sentiment while fighting deflation concerns?

ECB needs more than interest rates

Theoretically, it could be argued that the ECB has used up all their ammunition when it comes to monetary policy.

With Interest Rates at 0% for the past four years, alongside the Coronavirus pulling on both sides, with lockdowns forcing businesses to close and consumers to save, a liquidity trap may be underway. The strength of the Euro also gives the ECB limited room to move rates lower. This harks back to the Bank of Japan's issue during the financial crisis, with analysts predicting disinflation, therefore boosting the Yen, thus boosting fears of inflation - a never-ending cycle.

Only useful tool is asset purchases – however, it may have a side effect of boosting the Euro further

The ECB has purchased over 1.85 Trillion Euros worth of assets during the wake of the Pandemic. However, we may see a situation unfold similar to that of the Fed and US Equities – where the Fed's unwavering support for the US economy has had the side effect of boosting US equities. Further purchases may see an influx of capital in European Equities, increasing the demand for the Euro.

Since the strength of a currency is relative, some analysts predict the only way for the ECB to escape the cycle of a strengthening currency and deflationary concerns is through outperforming the Fed when it comes to asset purchases. Salman Ahmed, global head of Macro at Fidelity International, stated that "In currencies it's the relative game that matters," and that "You can argue that the ECB has been very aggressive in its policy, but has it been more aggressive than others? If the ECB wants to get the Euro down, they will have to outgun the Fed – there is no other way."

Euro Strength may be the Achilles heel for exports

The Euro sees its longest streak in 15 years on the back of Christine Lagarde, announcing that the ECB will provide an extra $1T in stimulus to combat the effects of the Coronavirus. The Euro against the USD has spiked to 1.127 to just under 1.135 on the back of extra stimulus. Pointing to inflation and price stability as concerns, Christine Lagarde stated a “unanimous view that action had to be taken.” However, with over six years of Quantitative easing and negative rates, the Euro’s weakness has benefited its exporters. This may change as the ECB puts its foot down in trying to rescue Europe.

History of the Euro post Financial Crisis

The European Union was hit hard during the Financial Crisis, with the Annual GDP growth rate dropping to as low as -6%. Europe did experience some GDP growth in the early 2010s, however, quickly reverted back due to the strong Euro dollar. Mario Draghi, ECB’s president at the time, implemented a drastic Quantitative easing program alongside negative interest rates. This gave the European union the boost it needed, with GDP Growth staying positive alongside the Balance of Trade, also staying positive in the following six years.

Balance of Trade of the Euro Zone over the past 20 years. You can see exports pick up around 2014
Euro Zone's GDP over the past 10 years

However, there has been a different tone from Lagarde, even before the Coronavirus pandemic.

With negative interest rates, investors in the European Union struggled to find yield while the American financial markets were experiencing capital appreciation alongside positive yield. Draghi consistently held that “for rates to be higher in the future, they need to be negative now.” However, with a change of leadership in the ECB at the turn of the decade, Lagarde is seen to take a tepid tone when it comes to negative rates. This was explicitly exemplified during the peak of the Coronavirus. When central banks all around the world were slashing their rates, Lagarde stood firm and kept rates as is. Lagarde is looking at the long-term future of the European Union and is possibly using the current pandemic to spur a change. However, with Lagarde’s new focus on getting out of this real negative rate environment, this may bode detrimental to exporters in Europe. A stronger Euro means it will cost more for buyers of European exports to purchase the Euro, possibly turning around their positive balance of trade.  

ECB Interest rate

What is the future of the Euro?

The Euro Dollar is currently at a key resistance around the 1.15 level, which has not been consistently able to break since quantitative easing and negative rates were implemented in 2014. We need to see if bulls will break this resistance, solidifying markets consensus for a strengthening in the Euro. If it sees a rebound at around this level, we may see a deep contraction to the downside.