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Euro surge poses new headache for the ECB

Euroboom is firing on all cylinders.

A strengthening eurozone economy, expectations of monetary policy tightening, and tumbles in the US dollar have all combined to propel the euro to its strongest level in three years.

The currency’s real effective exchange rate is up nearly 4 per cent since last June, when Mario Draghi, European Central Bank president, jolted markets with a reminder that the ECB has vanquished the threat of deflation. His now famed speech in the Portuguese coastal town of Sintra prompted investors to rethink their expectations for a scale back in the eurozone’s emergency-era stimulus measures this year.

Having been dulled by more than two years of ECB bond-buying, the euro is the best performing G10 currency this year. Its real exchange rate is now at its highest level since before the start of QE in 2014 rising seven per cent in 2017 (see chart above).

The single currency has also surged to an eight-month high against the pound and is at a near three-year peak against the dollar as Brexit and Donald Trump dramas weigh on both respectively.

But the euro’s surge is not without problems. In particular, the currency’s strength will exert a dampening effect on inflation, which the ECB expects will still undershoot its target in 2019 at just 1.6 per cent (target: just below 2 per cent).

“The exchange rate matters”, says Kallum Pickering at Berenberg, who notes the ECB’s latest inflation forecasts were made before the Sintra speech in May. He calculates the currency’s climb since then will knock off growth and inflation by 0.2 percentage points in 2018 and 0.4 percentage points in 2019.

“That would be a significant impact. It could imply a slower pace of tapering next year”, adds Mr Pickering.

Taha Saei, economist at Oxford Economics, thinks the exchange rate’s biggest pinch will fall in the first half of next year “taking off around 0.2 percentage points from headline inflation”.

But Mr Saei thinks the currency headache won’t be enough to throw the ECB’s tapering plans off course:

The ECB will take a gradual and well-communicated approach to reducing the pace of its asset purchases, starting with a €20bn per month reduction in the first half of 2018 (from €60bn per month now) – due to be announced this autumn.

The euro is also expected to find support from upcoming September elections in Germany where polls point to a victory for incumbent chancellor Angela Merkel. Meanwhile the prospect of elections in Italy have been pushed out to the spring.

Still, analysts at Bank of America Merrill Lynch think the upward trend against the dollar could soon reverse as the market is over-estimating the pace at which the ECB will tighten and underestimating the speed at which the Fed will raise interest rates, helping the euro fall back from its giddy heights:

The decoupling of the eurozone from the US is not sustainable. The latest relative data surprises already point to EURUSD downside risks. We expect the ECB to taper QE very slowly this fall, stretching it until the end of 2018. The market is ignoring the unwinding of the Fed’s balance sheet and is pricing too little in terms of hikes.