Could a stronger euro bring relief to global markets?

The European Central Bank is set to end its negative interest rate policy. That should bring some relief to markets, says John Stepek. Here’s why.

There are a few contenders for the title of “most important price in the world”.  

The most important is probably the US ten-year Treasury yield – that is, the interest rate that the US government has to pay to borrow for a decade.  

This is generally regarded as the global “risk-free” rate. It’s not too much of an exaggeration to say that every other asset in the world is priced with reference to this slab of US government debt.  

But a close runner up is the US dollar.

A strong US dollar sucks money out of risk assets  

The US dollar is one of the most important prices in the world.  

It’s the global reserve currency – everyone needs US dollars. As a result, when the price of US dollars goes up, you can view it as monetary policy getting tighter around the world (that’s an oversimplification, but it’s quite a useful one). 

This is at least one reason markets have struggled in recent months; the Federal Reserve, America’s central bank, has been ahead of other economies in terms of raising interest rates, while the US economy has also looked relatively resilient. The US dollar is also a “safe haven” asset, which means that it benefits when investors are feeling jittery.  

As a result of all this, the dollar has shot up in value against other major currencies. And risk assets don’t like that one tiny bit. As my colleague Dominic pointed out earlier this month, “if the US dollar keeps rising from here, it’s going to hurt”

The good news is that after a burst higher, the dollar is now a little lower than it was when Dominic wrote that piece.  

One key reason for that is the European Central Bank (ECB) – we’ll explain why in a minute. First, what’s the ECB done?  

Well, yesterday, ECB chief Christine Lagarde came out with a blog post in which she – unusually for a central banker – was really quite clear about what the central bank will be doing over the next couple of quarters. 

To summarise, she said that the ECB will stop printing money soon, it will start raising interest rates in July, and by the start of October rates will be back to 0% (ie, out of negative territory).  

That’s quite an emphatic change for the ECB. As Marcus Ashworth says on Bloomberg, “I struggle to recall any central banker, certainly not one from the ECB, ever having been this definitive about the monetary policy outlook.”  

There are probably two reasons for it. One is that the ECB has been lagging somewhat. Inflation has taken off in the eurozone too, but unlike the US, the economy has looked weaker so it’s been a tougher juggling act. But now it looks as though the hawks (for want of a better word) have won.  

The second reason is that the euro was threatening to hit parity with the US dollar. In pure market terms, parity is just another number, no more or less significant than 1.01 or 0.99. But of course, it’s not actually just another number; it’s a big scary round number and one that grabs headlines. It’s probably best avoided if possible.  

Part of a central bank’s role is to act as the guardian of the currency. That’s even more important in the eurozone than elsewhere because the euro is young and the lack of full political union between all of its member countries means there are still serious fault lines that could threaten its existence.  

This risk has retreated greatly. During the sovereign bond crisis of the 2010s, the ECB, under Mario Draghi, effectively won the right to print money to suppress national bond yields – and thus underwrite the solvency of individual eurozone nations – where necessary.  

But it’s better not to get to the point where markets decide to test your resolve on that front.   

Why a stronger euro might be good news for markets 

So why is this good news from a strong dollar front?  

Because the euro is the “other” global reserve currency. It’s miles behind the dollar in terms of being stockpiled by central banks around the world, but it is the biggest component in the “DXY” index which measures the dollar’s strength against a basket of rival currencies. It is probably the most widely-watched barometer of dollar strength. 

As a result, when the euro bounces against the dollar, DXY tends to fall.  

And what with this being quite a hawkish turn for the ECB, the euro rallied from falling as low as $1.03-ish last Friday, to heading above $1.07 now.  

Meanwhile, on top of that, it helped that one of the monetary policy setters at the Fed – Raphael Bostic, the head of the Federal Reserve bank of Atlanta – said that it might make sense for the Fed to pause for breath in September on interest-rate rises.

That’s hardly a wildly dovish statement (it implies half-point increases in both June and July), but with the market currently sweating that Fed boss Jerome Powell hopes to inherit the mantle of inflation destroyer from Paul Volcker, any sign that the central bank might relent is welcome to investors.  

A weaker dollar would be good news for investors, as it implies that the rush for safe havens will ease and investors will start seeking risk again.  

That doesn’t mean it’ll happen. However, one feasible scenario in which this might continue is one in which inflation ebbs (even while remaining high) and other central bank policies start to converge with that of the Fed. 

That’s certainly possible over the coming months. Does that mean you should be piling in as if everything is back to the tech bubble days? Not at all; the environment has changed and the winners over the next phase will differ from those of the last.  

But it does imply that the “crash-y” behaviour we’ve seen since the start of this year might be due a breather. Fingers crossed.  

For more see:  

If the US dollar keeps rising from here, it’s going to hurt 

The tech bubble has burst, but I still want a Peloton 

Recommended

3 renewable energy stocks to buy
Investments

3 renewable energy stocks to buy

These stocks look poised to benefit as the world transitions to a net zero economy.
31 May 2023
When can you retire?
Pensions

When can you retire?

An opaque outlook for the official state-pension age makes planning harder.
31 May 2023
Is it time to give up on buy-to-let?
Property

Is it time to give up on buy-to-let?

The number of buy-to-let mortgage products has plummeted in recent weeks, placing further strain on a market in which landlords already seem to be giv…
31 May 2023
30% jump in shareholder voting - how can you vote in upcoming investment trust AGMs?
Investments

30% jump in shareholder voting - how can you vote in upcoming investment trust AGMs?

The number of investors voting at AGMs has shot up since 2021 by 30% - but many still do not vote. With key votes coming up, here is how you can have …
31 May 2023

Most Popular

Best savings accounts – May 2023
Savings

Best savings accounts – May 2023

Interest rates have been creeping up - we look at the best savings accounts on the market right now.
31 May 2023
Nationwide to give £100 cash boost to customers
Personal finance

Nationwide to give £100 cash boost to customers

Nationwide Building Society is giving customers £100 as it reinvests profits. Dubbed the Nationwide Fairer Share scheme, we look at who is eligible.
22 May 2023
One day left for households to claim the £200 Alternative Fuels Payment to help with heating bills
Energy

One day left for households to claim the £200 Alternative Fuels Payment to help with heating bills

Households could be due a £200 payment if they heat their homes using alternative fuel sources and aren’t connected to the mains gas grid - but time i…
30 May 2023