Is the euro on the eve of a tipping point?

The euro has skyrocketed since the turn of the year. At the moment, signals that the currency will soon take a step back are piling up. There is a good chance that the European Central Bank (ECB) will give the go-ahead for that movement next week (at its meeting).

On Wednesday, January 24, you got a whopping $1,23 for $1 on currency markets. That is much, much more than 1,5 years ago, when the US and European currencies were worth almost the same. Some parties are already predicting that the euro could advance towards $1,30 or even higher. However, there is a good chance that it is precisely the strength of the rise that has sown the seeds for a turnaround in the foreign exchange market. The ECB holds the key in this regard.

ECB is about to change course
The strong appreciation of the euro mainly hides the expectation that the ECB will stop buying government bonds and that it will also raise interest rates this year. In the United States (US), the Federal Reserve has already raised interest rates 5 times in recent years. There will probably be 2018 more increases in 4. If the ECB does nothing, the interest rate differential will become very large. More and more traders are therefore anticipating that the bank will take an advance on the termination of the purchase program at the meeting on January 25 and 26.

Although the reports from the previous meeting show that the ECB is warming up to a policy change, there are 2 reasons why the bank is slowing down. The first is inflation. It is still well below the official target of 2%. In December inflation in the eurozone stood at 1,4%. That percentage will increase somewhat in the course of January, but that is primarily a result of the higher oil price† The core inflation, which ECB President Mario Draghi is closely monitoring, is not a reason to adjust current policy for the time being.

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The second reason why the ECB will not make a policy reversal this week is the strong rally of the euro itself. The currency's gains in territory threaten to erode the competitive position of European companies. Officially, the ECB has no target for the exchange rate of the currency, but the expensive currency is a thorn in Draghi's side. He will not be happy to make a move that will give the euro another boost.

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All in all, there is a good chance that the ECB will take a different tone this week than the currency world is counting on. In that case, the euro will probably have to give up a good part of its recent gains again. On the other hand, the way for further euro appreciation is not automatically open if the bank hints at suspending the asset purchase program and raising interest rates. In that case, the focus will shift to the Italian elections next spring and the difficult Brexit negotiations that lie ahead. And those are not exactly things that will further fuel the euro rally.

Lawrence Martins

Laurens Maartens is a currency expert at the Dutch Payment and Exchange Company (NBWM). Maartens analyzes current currency developments and also provides lectures and training in the field of currency management.

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