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Will Euro Kill Euro Zone Recovery?

Dimitri Vervitsiotis | The Image Bank | Getty Images

Who would have thought that a speech about a bumblebee could have such an effect?

When European Central Bank President Mario Draghi gave that speech last July ("The euro is like a bumblebee. It shouldn't fly but instead it does") — and of course, also pledged to do "what it takes" to preserve the euro — he started in motion a rally in the common currency that has only accelerated in recent weeks.

And for the past several weeks, the prospect of aggressive monetary easing in Japan has sent the euro rocketing higher against the yen, rising more than 11 percent so far this year.

All this begs the question of whether the euro's rise could stifle the very recovery it seems to reflect. Can the halting improvement in economic conditions continue? Or will the strong currency put such a dent in exports that key industries and already-fragile national economies falter or flag?

"The strong euro is clearly a problem, because it has been so broad based, and because it compounds other problems on the growth front," says Jens Nordvig, head of fixed income research, Americas, and global head of FX strategy at Nomura Securities.

Already, his firm's European economists are expecting euro zone "growth" of -0.8 percent in 2013, and the European Central Bank also sees the economy contracting. And while Nordvig doesn't expect what he calls investors' EURphoria to last, he says that for now, expectations of further appreciation are high.

Nick Bennenbroek, head of currency strategy at Wells Fargo, also sees the euro higher near term.

"An ongoing improvement in Eurozone bond markets and a shift in the European Central Bank's rhetoric have driven the euro higher, and are also factors that have reduced our medium term pessimism on the single currency," Bennenbroek told clients. He does expect the euro to soften eventually, but says, "it will probably take a relapse in the economic data or a return to dovish central bank rhetoric."

The euro has weakened going into Thursday's ECB meeting, which investors are watching closely. But there appears to be little on the horizon to truly stall its near-term rise. Even an explicit warning from French President Francois Hollande has not materially changed the currency's upward trajectory - especially given the highly bearish yen sentiment in the market.

The good news is that the euro's current level may not cause as much pain as some fear.

"I don't think EUR at 1.35 vs 1.30 makes a big difference," says Steven Englander, global head of G10 FX strategy at Citigroup. "On the margin, translation losses will begin to affect profits," he told me, but "it is wrong to look at the euro in isolation. A strong euro has come with a fixed menu of better confidence, rate convergence and stronger asset markets. Euro weakness has been associated with potential for disaster that outweighed any possible competitive gains."

Impact of a 10% appreciation of the Euro Trade Weighted (NEER) as per ECB (percentage deviation from baseline, cumulated)

Year 1 Year2 Year3
Real GDP -0.2 -0.6 -0.9
HICP -0.3 -0.9 -1.4
Export volumes -1.2 -1.9 -1.9
Export prices -2.1 -3.4 -3.8
Import Volumes -0.6 -0.8 -0.7
Import prices -3.3 -5.1 -5.4

The strategists at Bank of America Merrill Lynch are equally unruffled by the euro's strength. They argue that the euro's appreciation has been from a very low level, and that the impact on trade may not be as severe as many fear. They also calculate that the currency would have to reach 1.45 against the dollar "to substantially affect the euro area's outlook."

The euro's prospects will be significantly clearer on Thursday after the European Central Bank meeting. If officials there "are worried about the level of the euro, investors should be as well but if they express no concerns, it would be a green light for further gains in the currency," says Kathy Lien, a managing director at BK Asset Management.

Lien points out that Draghi was comfortable with the euro's level, around 1.3100 against the dollar, at the ECB's last meeting. And she is expecting more of the same on Thursday: "we expect the ECB to have a similarly nonchalant attitude about the currency as long as it remains below 1.38," she wrote in a note to clients.

Stay tuned.

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