- Draghi provides compact summary of financial crisis in Europe, what went wrong, and plans for recovery.
- True banking union is providing the "singleness" of the euro - the currency crisis has passed.
- Increasingly negative real rates should provide further economic stimulus and cap currency gains.
Mario Draghi, the President of the European Central Bank (ECB), made a major policy speech in Paris on Tuesday, March 25, 2014. It was a well-formed, compact summary of the financial crisis in Europe, what went wrong, and the plans and prospects for recovery. Draghi did not take the opportunity to talk the euro (NYSEARCA:FXE) down. The speech was primarily focused on the domestic conditions for recovery, so in that respect, the exchange rate of the currency is not as salient a topic. However, there were two key moments in the speech that spoke directly to the currency's level.
First, Draghi underlined the viability of the single euro currency in a section called "Restoring the singleness of money." During the depths of the crisis, it became quite fashionable for some pundits and analysts to predict the eventual demise of the euro in terms that suggested the conclusion was quite obvious. Yet, here we are with a stubbornly resilient euro that never even got close to parity against the U.S. dollar at the depths of the crisis. The crisis low in 2012 failed to make a fresh post-crisis low and the euro has chopped upward ever since. As Draghi pronounced in his speech: "In my view, the turning point has passed, and it came in the summer of 2012."
The euro keeps grinding higher although recent breakout above double-top was short-lived
Draghi states that "…for there to be a truly single money among sovereign countries, there has to be fungibility of deposits across borders…By reinforcing the singleness of money, the banking union provides the conditions for a lasting reintegration of the single financial market." Financial fragmentation and fears of "redenomination risk" put this fungibility into question until the ECB took decisive actions to restore confidence in the currency and the ECB's resolve to defend the currency (for example, the Outright Monetary Transactions (OMT) program). The euro area is now proceeding well with a true banking union that goes beyond a "juxtaposition" of national banks. In November, the ECB will launch its Single Supervisory System (SSM) that establishes the principles of the single banking union.
So, there is every reason to believe the euro has bottomed. The currency should also be topping out around current levels. Increasingly negative real rates provide the second dynamic important to the level of the euro. Draghi noted that by keeping interest rates extremely low well after inflation starts to pick up, real rates become increasingly negative, providing more stimulative policy:
"…we have not only cut interest rates to our lowest level since the creation of the euro, but we have also introduced forward guidance, whereby we commit to keep our policy interest rates as low as they are currently or even lower for an extended period of time…our forward guidance implies that short-term real rates, which are negative today, will become even more negative in the foreseeable future. This is because our policy rates will remain low or lower in nominal terms, while inflation is projected to gradually pick up. In turn, expectations of lower short-term real rates are reflected in the level of medium-term real rates, those that are most relevant for investment decisions by entrepreneurs. In this way, our guidance on the level of rates tomorrow, and the day after tomorrow, supports investment today."
Presumably, the trend for real rates in the eurozone will diverge from the real rates in other economies, like the U.S. and the U.K., with more advanced recoveries. Under "normal" conditions and all else remaining the same, the euro should weaken. If inflation does not creep higher as forecast, the ECB stands "ready to take additional monetary policy measures that ensure [its] mandate is fulfilled."
Overall, Draghi's speech was a comprehensive and convincing summary of the reasonable prospects for recovery in the eurozone. I remain short the euro because of an ongoing thesis that a weaker currency is another key ingredient to supporting the recovery. As the chart above shows, this is a counter-trend view with both the 50 and 200-day moving averages (DMA) grinding steadily higher for EUR/USD. As a result, I have had to manage a portfolio of euro shorts where EUR/USD forms the core and other currency pairs have provided shorter-term plays of fading euro rallies and closing out on dips. As I pointed out two months ago, the large dip in EUR/USD in late January on poor jobs and inflation numbers was the last complete close-out of euro short positions. The last jobs and inflation numbers triggered a surge and marginal break of the presumed double-top (again, see chart above). I strongly suspect the report next week will generate yet another important pivot point.
Be careful out there!
Additional disclosure: In forex, I am net short the euro.