If there was anything remarkable in the foreign exchange market in the early weeks of this year, it was the rise in the euro-dollar exchange rate. It rose to 1,20. The reason for this is the expectation that the European Central Bank (ECB) will tighten monetary policy sooner and that the bank will raise interest rates sooner (end of 2019).
Of course, this expectation did not arise by chance, but was caused by the publication of the summary of the board meeting from December last year. It states that the ECB may start changing the monetary course for the rest of this year and 2019 in a few weeks (in March).
This was almost immediately translated on the financial markets as saying that the ECB will stop buying government bonds sooner. In addition, the ECB is expected to raise official interest rates in March 2019. The euro-dollar rate rose to 1,20 due to this news. German long-term rates, especially the 5-year and 10-year rates, also climbed higher. This is in response to a faster than expected end to the era of unconventional policies in the euro country.
Expecting the ECB to tighten monetary reins (sooner than expected) makes sense. After all, the bank allowed it to celebrate for quite some time to boost inflation and economic growth in the euro country. That is now a fact. The eurozone economy is growing by almost 3%, the fastest growth since 2007, and the prospects for this and next year are good.
Inflation is currently around 1,5% and it is expected to rise further in the near future. Still, there is a good chance that the market will go wrong, with expectations of a rapid unwinding of monetary policy and the first interest rate increase in years in the first quarter of 2019.
Inflation remains too low
First of all, even though inflation has risen significantly, it is still too low. The bank aims for approximately 2% monetary depreciation per year, and it must be fairly certain that price increases can and will continue at that pace. Although the prospects are that inflation will rise, even then it will remain too low for the bank.
Moreover, this increase can only be expected if the ECB does not tighten the monetary reins significantly. If the bank does so, there is a good chance that inflation will drop again. And it is, I repeat, already too low for the European monetary knights. Pushing down inflation is just about the last thing the ECB wants to cause.
Unrealistic scenario?
Secondly, the report of the meeting clearly states that an adjustment of the monetary policy will only occur if growth and inflation continue to pick up. Whether that happens and to what extent remains to be seen. However, the ECB is cheerful about the state of affairs on the economic front and on the inflation front, which is understandable given the good economic news.
In line with this, it is expected that the bank will gradually make monetary policy less loose. However, because everything is still uncertain and inflation (as it currently looks) will remain low for a long time, the expectation that the ECB will stop buying bonds in September seems unrealistic to me.
Just as unrealistic in my view is the expectation that the bank will increase the official interest rate in March 2019. This will only happen if inflation in the euro zone rises significantly this year, faster than expected, and the ECB's calculations show that monetary depreciation will exceed 2% in the coming years.
Factor Draghi
My expectation is that the ECB has taken the path of a less loose monetary policy. I would be surprised if the bank is still buying government bonds in March 2019. I expect the first interest rate increase to take place in September 2019. On the one hand, because the euro zone will then work without the QE crutches for six months and the ECB can then judge how the economy is doing without that support, and on the other hand, because current ECB President Mario Draghi must leave the bank in November.
Given the economic situation in the eurozone and based on everything I have learned in recent years about Draghi and other European central bankers, it would not surprise me if interest rates were raised in September. This is to ensure that Draghi does not go down in history as a president who did not raise interest rates once during his presidency.
Closer to home, the above means that we should not be surprised if the euro-dollar exchange rate drops again towards 1,10 in the coming months. In addition, 2018 is a special year from a monetary perspective. For the first time, two major central banks, the ECB and the Fed, are making their policy less loose.
This will have major consequences on the markets, for the value of the euro, but also for interest rates in the euro country: from EURIBOR rates to long-term interest rates. That is why DCA announced a training Financing and capital markets organizes in Lelystad, where we will delve deeper into the course of the ECB and the Fed and the expected consequences for this and next year.