ECB faces surging euro conundrum

Reuters

2 days ago

LONDON, June 2 (Reuters) - While the European Central Bank keeps cutting interest rates, the euro keeps rising, as a transatlantic capital reversal upends relative rate shifts and threatens to force the ECB into further easing.
The ECB is widely expected to lower its main borrowing rate on Thursday to 2%, half what it was at its peak a year ago and less than half the Federal Reserve equivalent. It's also back to what the central bank broadly considers a 'neutral' level, meaning it neither spurs nor reins in the economy.
Real, or inflation-adjusted, ECB rates will be back to zero for the first time in almost two years.
What's remarkable is that after eight consecutive ECB cuts and with the prospect of zero or even negative real rates ahead, the euro has surged more than 10% against the dollar in just four months and 5% against a trade-weighted currency basket of the euro zone's major trading partners.
That nominal effective euro index is now at record highs, with the 'real' version at its strongest level in more than 10 years.
The currency has surged even though there has been no net change in the gap between two-year government bond yields on either side of the Atlantic - usually a reliable indicator of shifts in the euro/dollar exchange rate.
The culprits behind this trend are pretty clear: Donald Trump's tariff wars, fears of capital flight from dollar assets due to a host of concerns about U.S. policies and institutions, and Germany's historic fiscal boost that has transformed the continent's outlook.
But if even a fraction of the trillions of dollars of European investment capital in the United States is indeed coming back home as many suspect, the ECB has a curious conundrum ahead. How does it handle both the disinflationary effects of such a rapid currency rise alongside the domestic demand it could catalyse?
Lower rates with the prospect of further easing ahead are clearly having little impact on the euro. Most ECB watchers expect one or two more cuts after Thursday while money markets have a 'terminal rate' around 1.75%, the low end of the ECB's estimated range of 'neutral'.
Indeed, if much of the capital repatriation from overweight U.S. holdings is in equity investments, then lower ECB rates may even accelerate the outflows from the U.S. by lifting growth prospects for cheaper stocks in Europe.
The prospect of higher German and pan-European borrowing should sustain longer-term fixed income returns as well, expanding the pool of 'safe' investments.
The ECB could revert to protesting about 'excessive' euro gains, although the impact might be limited unless it is prepared to back its words with action, and there is a risk it could backfire for the reasons just mentioned.
If anything, the ECB appears to be encouraging the investment shift and the euro's role as a reserve currency - in part to help with the bloc's massive capital needs in retooling its military, digital and energy sectors.
In a pointed speech in Berlin last week, ECB chief Christine Lagarde insisted there was an opening for a "global euro moment", where the single currency becomes a viable alternative to the dollar, earning the region immense benefits if governments can strengthen the bloc's financial and security architecture.
The scenario may be seen as a nice problem to have, but there will be more than a little disquiet among the region's big exporting nations about a soaring exchange rate in the middle of a trade war.
ECB hawks and doves will also have to thrash out whether continued easing to offset disinflationary currency risks only stokes domestic inflation over the longer term - not least with a fiscal lift coming down the road into next year.
What seems clear is that the ECB's new economic forecasts due for release on Thursday will have taken into account the 7% euro/dollar gain and near 10% drop in global oil prices since its last set of projections in early March.
Morgan Stanley economists reckon that even if the central bank tweaks its core inflation forecasts higher, the new outlook could well show headline inflation undershooting its 2% target from mid-2025 to early 2027 - even while nudging up 2025's GDP growth view.
In truth, any forecasts at this point are fingers in the wind with few central banks or major investors having a clue where U.S. tariffs or retaliatory trade war actions will end up.
But while global trade and investment nerves abound, the ECB may be relatively powerless to cap the euro. Whether that argues for stasis or even more easing is the big headache it faces.
The opinions expressed here are those of the author, a columnist for Reuters