Is The Euro Low Risk-High Reward? It Depends On Policy

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Summary

Strength of the euro depends in large part on future ECB policies.

Targeting the yield curve rather than relying on prolonged quantitative easing appears a more viable strategy for the euro area at this point.

Should such a policy come to fruition, it is likely we will see the euro strengthen from here.

Previously, I had made the assertion that the euro will come to be an attractive currency in the next year. We are already seeing the currency make significant gains against the pound in light of Brexit, and given that the euro fell by a very significant amount against the dollar in 2015, there is a case for a low risk-high reward long trade.

However, much of this hinges on central bank policy going forward. At the risk of overstating the obvious, QE and a low interest rate methodology has all but been exhausted at this point. As opposed to encouraging greater consumer spending, this has not been as great as anticipated since there has been no clear indication as to when rates will rise again, and low rates have consequently hurt bank profitability. In particular, the inflation rate of 0.4 percent in the Euro area is still well below the 2 percent target.

Japan has recognized the problems resulting from prolonged quantitative easing, and Kuroda has changed tack by targeting the yield curve rather than interest rates as a lever to boost spending. In this context, the rates lent out on longer-term yields by banks are higher than that of the short-term yields on borrowed cash, leading to a steepening yield curve and allowing for a greater level of consumer spending in anticipation of rising rates, which concurrently pushes inflation rates higher.

This policy has not been ruled out by the ECB. Indeed, it is one of a very limited number of options remaining after extensive quantitative easing measures have been exhausted. While Europe has seen somewhat of a flattening of the yield curve since 2015, this has not been as extensive as that of Japan's, where the country is following a much more stringent policy in this regard.

The extent to which the ECB will or will not follow through on such a policy and to what extent is unknown at the moment. However, a signal that they will is likely to have a positive effect on the euro, as anticipation of higher rates is likely to lead to greater euro demand. Moreover, economies such as Australia which have seen significant strength in their currency have shown particularly flat yield curves. On this basis, we could well see the euro go higher if such a policy shift becomes apparent.

To conclude, I still maintain that the euro is a low risk-high reward currency. Quantitative easing is running out of steam across virtually all developed economies, and indications of higher rates will likely provide a much needed boost to the euro.

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