Currency Brief: Euro continues to test new highs; end not in sight

on Dec 11, 2013
Updated: Oct 21, 2019

The EUR/USD climbed for a sixth day yesterday, the longest run in almost a year, as European finance ministers met in an attempt to break the impasse over a single resolution mechanism for failed European banks.

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The euro reached its strongest level in almost six weeks against the greenback due to reports showing that Italy’s industrial production had grown and its economy had stopped shrinking, boosting optimism that the Eurozone region is finally in sustained recovery.
The euro has now advanced eight per cent against the dollar since the march started in early July. This remarkable performance has been accomplished despite the widely-held perception that monetary policies at the European Central Bank and the US Federal Reserve are set to diverge, with the Fed starting to pull back on its bond purchases and the ECB considering even more accommodative measures. Such divergence, if it comes to pass, will translate into a stronger dollar.

But the picture is not as simple as it seems. In the United States, markets appear to have accepted the Fed’s proposition that a tapering of bond purchases doesn’t signal an imminent rate hike. In other words, that tapering doesn’t equal tightening. Two-year US yields have in recent times fallen back to 0.3 per cent. And the ECB’s path to loosening is attended by difficulties; last Thursday’s ECB press conference largely disappointed market participants looking for further immediate action. Two-year German Bund yields have risen sharply so far this month. The relative appeal of higher dollar yields has faded.

Even if the Fed does ease back on its bond purchases in the very near term, its balance sheet will still expand. By contrast, the ECB’s balance sheet has been shrinking since mid-2012, implying tightening liquidity conditions in the Eurozone. Indeed, as ING has noted, for the first time since 2008 European banks are willing to pay to get their hands on euros, as measured by the three-month cross-currency basis swap.

Moreover, investors are turning back to European stocks and bonds. According to Citigroup, flows into European equity funds in October were the strongest on record. Southern European government bond markets have also managed to attract foreign investors seeking higher yields. Both of those trends could well continue into 2014, according to analyst forecasts.

At some point though, the Fed and the ECB are likely to go their separate ways, given the weakness of the Eurozone economy and the relative strength of the US recovery. As noted earlier, such a scenario would boost the dollar sharply but it might take some time. For now, the euro seems unlikely to retreat from the high ground.
The Federal Reserve, Federal Deposit Insurance Corporation and three other agencies yesterday formally adopted the proprietary trading ban known as the ‘Volker rule’. Its imposition on American investment banks has been contested by JPMorgan Chase, Goldman Sachs and other industry majors for more than three years. The Volker rule is designated to prevent future financial meltdowns, albeit many details are still to be worked out.
Wall Street lobbying has paid off to some extent though, in an easing of some aspects of the rule. As a case in point, regulators have conceded a broader exemption for banks’ market-making desks, on condition that traders aren’t remunerated in a way that rewards proprietary trading.
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