During the press conference, Mario Draghi acknowledged that the economic recovery in the Eurozone has been stronger-than-expected. In particular, the ECB staff has upgraded its 2017 GDP growth forecast from 1.9 to 2.2%, the highest growth pace since 2007. However, Mario Draghi expressed that the ‘recent volatility in the exchange rate’ represented a ‘source of uncertainty for the medium-term outlook for price stability’ and a downside risk for the growth outlook. Mostly because of the euro appreciation, the ECB staff has downgraded its 2019 core inflation forecasts from 1.7 to 1.5%, which is quite low.
Logically after such an appreciation of the euro (+7% in effective terms since April) , Mario Draghi has had to answer numerous questions about the exchange rate. While he has recognized that the euro appreciation constituted ‘unquestionably’ a tightening of financial conditions, he reasserted that the latter remained very accommodative and he did not appear overly concerned by this issue at the current exchange rate levels. Of course, a unwarranted appreciation of the euro would change the ECB’s plans.
Despite the low prints of underlying inflation and the recent euro appreciation, we expect the ECB to announce in October a reduction of its asset purchases for 2018. Mario Draghi did not appear really concerned on the question of bond scarcity but we think that the ECB room of maneuver in terms of QE extension is somewhat limited: on the top of that, he stressed that there was no plan to change the issue and issuer share limits.Besides,Mario Draghi has reiterated that the ECB has no intention to change the sequence of the removal of unconventional monetary policy measures: interest rate hikes will intervene after the end of net QE purchases.
The climb of the EUR/USD parity this year could be broadly explained by 1) the improvement of the macro and political landscape in the Eurozone and 2) political and geopolitical factors weighing on US yields. As a consequence, there has been a sharp tightening of the long-term interest rate spread between the United States and Germany. The 10y. yield spread tightened from 230 bps at the beginning of the year to 175 bps , what justifies a substantial appreciation of the euro vs the US dollar. It is very important to stress that the reduction of the long-term interest rates is not only a European story: US yields fell because of geopolitical tensions between North Korea and the US and might rebound in the short-run in case of easing of these tensions. However, we believe that in the medium-run, the spread will continue to tighten, what would contribute to a rise of the EUR/USD parity.
We expect the euro to continue to appreciate in the coming quarters.This trend should continue as we expect German yields to climb progressively in the coming months. A rise in European bond yields would likely make portfolio investment flows less negative and even turn them around into positive territory. Against a backdrop of the eurozone’s substantial current account surplus (€340bn for the last 12 months), future portfolio rebalancing is likely to be to the euro’s advantage. As a result, it is very likely that the euro’s upward trajectory will continue over the coming quarters.
More generally, we think that is important to stress that the era of ‘forever more monetary policy easing’ is now behind us: while the net issuance of long-term sovereign bonds in developed countries after central banks’ purchases was highly negative in 2016, it started to be less negative in 2017 and will be less and less negative in 2018 with the reduction of the Fed’s balance sheet and the reduction of the ECB’s asset purchases. The normalization of monetary policy planned by central banks is not completely priced in by financial markets and there may be monetary policy surprises like we have seen this week with the unexpected hike of the Bank of Canada.