This summer the U.S. dollar has had the best sustained performance against the euro in almost four years, gaining 9.7 percent versus the united currency in the five months since May 1st.
It has been the type of sustained move that currency traders treasure and that historically has been triggered by a change in central bank rate policy or a profound dislocation of the reigning economic and financial outlook.
But the diverging economic fundamentals and interest rate policies of the United States and the European Monetary Union have been evident since at least the beginning the year.
The EMU economy has stagnated, growing not at all in the second quarter. The three largest economies, Germany, France and Italy have had one positive quarter between them this year, while the U.S. has surged to 4.6% annualized expansion.
The ECB has been cutting its main-refinance rate for more than a year while the Federal Reserve has been reducing it securities purchases, its de-facto rate policy for much the same period and will end them next month.
President Mario Draghi and ECB officials had mentioned the drag that an expensive euro places on the EMU economies numerous times before May, making it clear that the bank preferred a weaker currency.
But despite the clear pro-dollar direction in ECB rhetoric, policy and economics there was little corresponding movement in the euro. From early March until early May the euro traded in a relatively narrow two and a half figure range between 1.3700 and 1.3950, with the majority of the trading between 1.3750 and 1.3900. In the final three weeks before May 8th the majority of the range narrowed further to 1.3800 to 1.3900.
Despite the weak-euro message that Mr. Draghi was trying to send, and the strong-dollar and rising interest rate policy that Ms Yellen, the Fed Chair, was trying to deny by stressing the ‘considerable period’ remaining for low U.S. interest rates, for the first four months of the year the markets were not paying attention.
But suddenly the equation changed. What happened in early May to convince traders that the euro’s time was up?
The catalyst was straight forward. In his press conference following the May 8th policy meeting Mario Draghi said that officials were “comfortable” with taking action. Mr. Draghi’s comfort was interpreted to mean that the ECB had gotten the necessary permissions to widen the scope of the bank’s policies to asset purchases and negative interest rates. Bank rhetoric had become a promise, the diverging ECB and Fed rate cycles were suddenly real.
For all the steadily worsening EMU economic and inflation statistics over the past year and the ECB’s recurring references to negative interest rates and asset purchases, it had been widely assumed that the opposition of the German Bundesbank would block ECB experimentation. And the German central bank and its President Jens Weidmann had emphatically not dropped their objections.
Mr. Draghi’s unusual statement convinced the markets that Angela Merkel, the German Chancellor had approved the plan to reflate the EMU economy and stave off deflation with a bout of Fed style of liquidity.
In the following three ECB governing board meetings the central bank has cut interest rates twice, enacted a cheap long-term loan facility for banks and announced a plan to buy assert-backed securities and covered bonds the terms of which will be detailed on Thursday.
The ECB’s message on May 8th was just the final piece of a picture that had been changing for many months. The rapid and unrelieved descent of the euro is evidence that the underpinnings of the united currency had long since melted away needing only the slight push of Mr. Draghi’s promise for a historic swoon.
Chief Market Strategist
WorldWideMarkets Online Trading