Euro rally overdone or start of new uptrend?

The euro’s relief rally following the receding threat of right- and left-wing populism in Europe after Macron’s election win in France has turned the euro to one of this year’s best performing currencies against the US dollar.

The presidential election in France was seen as a key test for European political stability, as well as the fate of the European Union (EU). A victory for the far-right candidate, Marine Le Pen, could have boosted far right movements in other European states and led the way to France’s exit from the Eurozone, possibly even the EU. Emmanuel Macron’s landslide victory over Le Pen signalled a shift in momentum away from extreme parties in Europe and ended months of uncertainty about the political direction of the Eurozone’s second largest economy.

With Germany’s Angela Merkel poised to win a fourth term as chancellor in September, the brightening political landscape in Europe has helped lift the euro to more than 6-month highs against its US counterpart. The single currency is up over 6% against the dollar so far this year. However, as the French election euphoria dissipates, other fundamentals have also been working in the euro’s favour.

The declining risk of political upheaval in the EU has been accompanied by growing political uncertainty in the United States. President Trump has been stumbling from one controversy to another since taking office in January, raising serious questions about his ability to see through his economic agenda, mainly the promised tax reforms and big infrastructure spending. With the prospect of a fiscal stimulus moving further into the future, many investors have pared back their expectations of a faster pace of rate increases by the US Federal Reserve.

This has been a key factor in driving the dollar down to pre-election levels against many of its major peers. The euro hit a 6½-month high of 1.1267 dollars on Tuesday as the greenback continued to be mired by the White House turmoil that followed the sacking by President Trump of the FBI director. However, the euro’s gains have been broad-based, rising against other majors such as the yen and the pound. The single currency has climbed to a more than one-year high against the yen, and is currently at an 8-week high versus the pound.

The newfound confidence in the single currency comes amid the backdrop of improving economic outlook for the Eurozone. Two years after the European Central Bank (ECB) launched its expanded bond buying program, growth in the euro area has finally started to pick up a gear, while the threat of deflation has dissipated. Since the start of 2017, Eurozone business surveys have been very strong and have consistently beat expectations, with both manufacturing and service industries showing sustained growth. Germany saw its Ifo business climate index rise to an all-time high in May, and the Eurozone’s composite PMI by IHS Market reached a 6-year high in April.

The strengthening economic picture in the euro area has already been acknowledged by the ECB, but the central bank seems less convinced by the recovery in headline inflation. Eurozone CPI has risen sharply to 4-year highs in 2017 and has technically met the ECB’s target of close but below 2%. However, the ECB is worried that underlying inflation is still too weak and that there is not enough evidence to suggest the upturn is sustainable. This stance was echoed again today by the ECB’s Vice President, Vitor Constancio and Chief Economist Peter Praet, as well as by President Mario Draghi himself.

Speaking in Madrid today, Draghi sounded more optimistic regarding Eurozone employment and consumption, but repeated that underlying inflation remains subdued. In a possible sign to what’s to come at the June meeting, Draghi said “there is no reason to deviate from the indications we have been consistently providing in the introductory statements to our press conferences”.

The comments are likely to disappoint some traders who are expecting the ECB to use the June 8 meeting to strike a more neutral tone and signal the start of withdrawal of monetary stimulus in 2018. Such expectations have been another reason for the euro’s resurgence in recent weeks.

The ECB has pledged to maintain its asset purchases at €60 billion a month until December 2017 and most analysts expect the central bank to announce at the September meeting a reduced pace for next year. There’s also been speculation that the ECB would begin to raise rates before it has ended its bond purchases, contrary to its current forward guidance. ECB policymakers have been keen to downplay such a scenario, and their reluctance to move away from the existing policy guidance suggests they will be choosing their language carefully if they decide to update their June statement to a less dovish one.

If the ECB decides to make only minor tweaks to its June policy statement, this will likely frustrate investors and could stall the current rally. In the meantime, should incoming US data surprise to the upside and the Fed sends fresh hawkish signals to the market, this could deal a double blow to the euro, though such an impact would only be temporary, as, assuming that the Eurozone economy remains in its existing growth trajectory, it would only be a matter of time till underlying inflationary pressures start to worry the ECB.