GO
Loading...

Why investors should be betting on a strong euro

Getty Images

The euro's decline following the hint dropped by the European Central Bank (ECB) last Thursday that it may ease its policy stance early next month is a trading event with little, if any, message for investors in euro-denominated assets.

There are two major reasons for that.

First, the ECB has no effective policy instruments to weaken the euro/dollar exchange rate in a credible and sustained fashion. All they can do is: (a) try to talk the euro down by saying, as they did last week, that fundamentals don't warrant the currency's appreciation, (b) drive money market rates to zero from 0.25 percent, and (c) engage in selective asset purchases that would be consistent with the bank's restrictive mandate.

Read MoreWill the ECB's euro bashing work?

None of that would be likely to create a large and sustained increase in excess euro supply to drive its relative price down, and to keep it down. A largely symbolic interest rate cut would certainly fall far short of that objective. Asset purchases would also be of doubtful effectiveness. In addition to being a highly controversial issue, they would not solve the problem of euro area banks' reluctance to lend to businesses and households at the time when they are facing a new round of presumably rigorous asset quality tests.

Second, investments in the euro area are driven by growth outlook, progress of the ongoing fiscal adjustment and the credibility of demand management policies. Investors, apparently, see significant positive changes in all these domains.

How else to explain the good performance of euro area bond and equity markets?

Read More'Overly strong' euro nears 7-week high

The governments' borrowing costs over the last twelve months have declined 3.4 percentage points in Greece, 2 percentage points in Portugal, more than a percentage point in Spain and 80 basis points in Italy. Similarly, the euro area stocks gained 2.4 percent since the beginning of this year, compared with no change on the Dow, virtually no gain in emerging markets and a 12.8 percent decline on Japan's Nikkei 225.

ECB's skillful market guidance

The ECB is aware of its limits to influence the euro/dollar exchange rate. Currency traders who may think otherwise are just reading too much into the ECB's noncommittal statement that it will have to see its own quarterly growth and inflation forecasts before taking any decisions on policy changes during the bank's next meeting on June 5, 2014.

I believe that the ECB will decide against any additional monetary stimulus. ECB President Mario Draghi said last week that the "moderate economic recovery" was "in line with expectations." The most recent survey data bear that out. Euro area business activity accelerated in April to its highest level in almost three years, and industrial production in the first two months of this year was growing at an annual rate of 2 percent, nearly double the pace of advance observed in the fourth quarter of 2013.

Read MoreEuro zone business activity at three-year high

I also think that the ECB is right in doubting the deflation scenario. Wages are picking up, unit labor costs are growing somewhere between 0.5 and 1 percent, and a gradually strengthening output does not suggest a danger of sustained price declines.

Markets, therefore, should not take it as a foregone conclusion that the ECB will join the U.S. Federal Reserve and the Bank of Japan with its own version of nonconventional monetary policies. The statement that the ECB "was comfortable with acting next time" is just part of talking the euro down.

Muzzling the politicians

Equally important is the fact that the ECB is trying to placate many constituencies – ranging from the French and Spanish government to the International Monetary Fund (IMF) and theOrganization for Economic Co-operation and Development (OECD) – calling for unspecified measures of "quantitative easing."

Read MoreBet on euro weakness amid QE talk: HSBC'sBloom

Spain's Prime Minister Mariano Rajoy stated recently that his government had done everything it could to support the country's recovery, but that it was now up to the ECB to deal with the depressive impact of the strong euro.

That call was echoed two weeks ago by the French Prime Minister Manuel Valls. He urged "a more active monetary policy and a more realistic exchange rate policy (sic) at the European level." It seems that the prime ministers' economic advisers believe, incorrectly, that there is an exchange rate policy independent from the monetary policy.

These attempts at political meddling with the euro's exchange rate led Mr. Draghi to warn last Thursday that the ECB's independence is guaranteed by an EU treaty, and that politicians should refrain from gratuitous policy "advices" because that could undermine the bank's credibility.

Read MoreEuro pulls off 2-month high; Draghi warns on excessive strength

Predictably, Mr. Draghi got help from the German chancellor, whose spokesman issued a stern statement saying that "the euro's exchange rate is none of the politicians' business; the euro's relative value is a matter for the ECB which acts independently and needs no political advice on what it should do."

That seems to have promptly disposed of a contentious euro issue the French media announced as part of the agenda for the summit meeting last Friday and Saturday between the French president and the German chancellor. True to form, Germany appears to have quashed the idea. Neither the official communiqué nor the leaders' press conference made any mention of the euro's exchange rate.

Investment thoughts

The euro area's exit, unbowed and whole, from its worst economic, financial and political crisis provides a strong underpinning to the global demand for euro-denominated assets. The monetary union's by far the largest current account surplus in the world – presently running at an annual rate of $330 billion – is also a structural feature of euro's robust exchange rate.

The ECB has no effective instruments to resist, even if it wanted to, these powerful tailwinds.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.

Follow the author on Twitter @msiglobal9.

Symbol
Price
 
Change
%Change
EUR1M=
---
.DJUSSC
---
.NKXQ
---

Contact FX