Not for the first time, the market is in need of a re-think on the single currency. I alluded to this at the start of the week (see “The euro dilemma”) for two reasons. Firstly, the backdrop was becoming less negative for the currency. Secondly, as we suggested ahead of the move, a cut in the refinancing rate was the least effective option available to the ECB.
The fact that the refinancing rate was cut to 0.25% barely matters for the currency, because what matters are market rates (swap, deposit etc.). These hardly moved, with 1 year swap rates going from 0.14 to 0.115. This is the reality of a world of near-zero rates and ample liquidity. For the longer-term, consideration has to be given to the impact on rates paid by households and businesses in the broader economy. These barely budged in the wake of the May easing and will move even less in the wake of last week's move.
With regard to the backdrop to the euro, we should think less about the fact that rates are near zero (that's hardly unique these days) and focus more on the inflation and current account dynamics. In recent history, when countries have been experiencing low (<1%) or negative inflation and running current account surpluses, they've tended to see their currencies firm. This has been the case for Switzerland 2008 onwards, less so 2002-07 when inflation was mostly above 1%. A similar, although less prominent pattern exists with the yen, given that rising inflation and a falling current account have undermined it over the past year (along with the onset of Abenomics nearly a year ago).
The reasons? Capital preservation (from low inflation) and an underlying faith that the country does not need to attract overseas capital every year, one of the means by which this can happen is via a lower currency, which then threatens to push inflation higher. And when the Fed moves towards tapering, markets will become more divisive towards those running current account deficits and those not. During the period between May and September of this year, when markets moved to price tapering, there was a distinct difference between those currencies running surpluses and deficits, because of the support that QE had given over the preceding period.
The same largely held true for the majors. During the early May to early September period, countries running current account deficits were the ones that depreciated vs. the dollar (Aussie, Canadian dollar, Swissie and kiwi), with the exception of sterling (reacting to stronger data). The surplus countries (Eurozone, Japan, and Switzerland) appreciated.
With US data likely to disappoint between now and the end of the year, a re-test of the highs just above 1.38 is currently looking more likely than a push towards 1.30, that is if the history of low inflation and surplus FX dynamics re-asserts itself.