ECB preview: 2 reasons to buy the euro regardless of the ECB’s message

Europe is in a tough spot.

The war in Ukraine led to a wave of economic sanctions against Russia and an unprecedented economic effort from European economies to support Ukraine.

On top of that, inflation is way higher than the European Central Bank (ECB)’s 2% target. Finally, the euro area economy has entered a technical recession.

All of that, and some more, argue for a lower euro. After all, how could a currency, a common one, succeed?

To all its credit, the euro holds up extremely well in such an environment. Some argue – too well.

Indeed, it currently trades at 1.08 against the US dollar or 152 against the Japanese yen. To many traders, the EUR/USD exchange rate belongs below parity.

But I would argue here that this is just a beginning of a more euro strength for at least two reasons. First, the interest rate differential with the Fed will shrink. Second, while under severe stress, the euro area economy is set to benefit from a robust recovery from the pandemic and a much improved public investment outlook.

Interest rate differential with the US shrinks

The Federal Reserve of the United States (Fed) announced yesterday that it kept its monetary policy unchanged. No hike – for the first time in 15 months.

Sure enough, the decision was accompanied by a hawkish press conference. More precisely, the Fed Chair, Jerome Powell, hinted at the fact that more hikes are likely needed in the future. Also, and perhaps more importantly, there will be no rate cuts in 2023.

But the market knows the Fed was wrong before regarding inflation. So why should we believe now the Fed gets its forecast right?

To me, something strange appears in the way the market forecasts future rate hikes. For instance, for July, there is a probability of over 60% for the Fed to hike.

But inflation in May came out at 4% – way below the estimate. Next month, the inflation rate is likely to drop further, even into the 3.5% territory.

So why would the Fed raise rates with, say, inflation at 3.5% when it paused at 4% inflation rate?

At the same time, the ECB still has room to raise the key interest rates. It will do so today and will likely remain hawkish.

Hence, the divergence between the two central banks should help the euro. And, if the EUR/USD exchange rate is supported on dips, then all the other euro crosses will be as well.

The euro area economy is well-positioned for solid growth

Geopolitical changes and the COVID-19 pandemic have posed challenges to all economies. In Europe, the war in Ukraine added fuel to the fire.

But Europeans did their job well. They acted much faster in the face of the new threats, and now it is time to see the results via stronger economic growth.

The labor market recovered from the pandemic, and now we are seeing labor supply shortages. As such, the pressure for higher wages should continue, and so, the central bank’s fight against inflation should take longer. Hence, this is bullish for the common currency.

Also, active fiscal policy led to a much improved public investment outlook. This is something that Europe lagged behind in the past.

Finally, Europe should benefit from higher productivity given by a scarce labor market and higher wages. That should be enough to keep a floor below the common currency and to provide a bullish bias in the medium to long-term horizon.