Opinion: Three ways Draghi could burn the euro bulls
Populists were about to storm the citadels of power in Paris and Rome. Countries would splinter away from the euro. Greece would be back in crisis, terror attacks would shake the continent, the departure of the U.K. would doom the European Union.
At the start of the year, the consensus view on the euro EURUSD, -0.0601% , and the European economy, was dire, with plenty of forecasters predicting it would soon be down to parity with the dollar.
It hasn’t quite worked out like that. Instead, Europe looks more politically united than it has in the past decade, and the economy is witnessing a cyclical upswing which, with any luck, may turn into a durable recovery. In fact, the issue now is that the euro is too strong — not that it is too weak.
But hold on. There is a problem with investors’ sudden love affair with the euro, and one they need to wake up to fast. They are reckoning without European Central Bank President Mario Draghi.
In fact, a strengthening euro is absolutely the last things he needs as he kindles the fragile flames of an economic recovery. Can he send it back down again? Sure he can. And traders would be foolish to try and fight him.
Over the last month, the euro has started to power ahead on the currency markets. At the start of this year, it was down to $1.04 against the dollar, and with difficult elections scheduled in France and the Netherlands it was not hard to see it going to parity or even below.
And now? Over the last few months, it has steadily climbed to $1.16, and it is still going up. In the last three months alone, it has put on more than 6%. In the markets, bullish bets on the currency have hit their highest level in more than a year, according to an analysis by Rabobank. A $1.20 rate looks like an easy target – and $1.30 may be possible by the autumn. It is not likely to hit the $1.59 it peaked at back in 2008, but there is no reason why it can’t keep climbing.
It is not hard to understand why the euro is suddenly strong again. With the victory of President Emmanuel Macron in France, the continent looks a lot more stable. Not only does he have a huge mandate, but if he can push through reforms to the way the currency works, he can take the risk of a break-up splintering off the table.
The ECB’s €2.2 trillion of quantitative easing has finally started to feed through into higher growth figures. Only this week, the International Monetary Fund upgraded its 2017 forecasts for most of the zone’s major economies — Germany by 0.1%, France by 0.2%, and Spain and Italy by 0.5%. Indeed, with a 3.1% expansion forecast for this year, Spain will have one of the fastest growing major economies in the world.
At the same time, with Donald Trump’s presidency looking more and more chaotic, the dollar BUXX, +0.00% is far less attractive than it was. The euro is a far better home for spare cash than most of the major alternatives.
The trouble is, a stronger currency is the last thing Europe needs right now.
Exports are the foundation of most of the major European economies, and as the currency gets stronger they will inevitably get hit. In peripheral Europe, where exports are based on price more than anything else, and where the recovery is most needed, they will be hit especially hard.
Indeed, stock markets across the continent have already started to suffer as investors figure out that the currency will hurt company profits and then jobs as well. The recovery needs to put down deep roots to repair the damage of the last decade — but a strong euro will stop that.
So what could Draghi do to turn that around? True, managing the foreign-exchange markets is an impossible task. But that does not mean he is completely powerless to influence the direction of the currency.
First, he could extend QE. With the economy recovering, and with the threat of outright deflation banished at least for now, there is lots of speculation that the ECB will start tapering its program of printing fresh money. In fact, that is one reason why the euro has been climbing. So far, Draghi himself has been fairly neutral on the issue, giving few clues one way or the other. But a strongly worded statement extending the scale and duration of QE would quickly have the trading desks unwinding all those bullish euro bets.
Next, change the asset mix. One reason there has been so much speculation about tapering QE is because the ECB may soon run out of government bonds it is allowed to hold. So buy something else. A powerful move into buying equities directly, or even an experiment with — and send the currency hurtling back down again.
Three, line up a dove as the next president. Draghi’s term does not end until 2019 but there is already jockeying to succeed him. The assumption is that a German will get the job next time. After all, it is their turn — and that means a stern Bundesbank hardliner. But making it clear it is likely to be a dove from peripheral Europe — Ireland’s Philip Lane is one possible candidate — would send a powerful signal the ECB is not going to change course.
In his six years in the presidency, Draghi has proved himself a smart operator.
When the history books are written, he may well go down as the man who saved the euro, and with it the European project. He surely knows, however, that a stronger euro is the one thing that could prevent his recovery lasting, especially in peripheral, Southern Europe where it is most needed.
At some point, he will decide to bring the currency under control — and you won’t want to be on the other side of that trade when it happens.