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.
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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?
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.