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A New Regime Takes Over At The ECB

Summary

  • Farewell to Mario Draghi, the ultimate dove.

  • The era of Lagarde begins.

  • A fresh program of QE greets the new leader.

  • Europe missed the train on U.S. leadership.

  • The euro currency remains under pressure.

(Seeking Alpha) The US dollar is the world's reserve currency. The dollar is the most widely held currency because of the political and economic stability of the United States. A reserve currency must be fully convertible to other foreign exchange instruments. The dollar floats freely, and the value of the greenback is a function of interest rate differentials and sentiment. Governments intervene in foreign exchange markets from time to time to maintain stability. Historical volatility in the world's leading currencies tends to be lower than stocks, bonds, commodities, or other assets.


The dollar index reflects the overall strength or weakness of the US currency against other leading world foreign exchange instruments. The euro currency comprises approximately 57% of the dollar index, as the euro is the second-leading world foreign exchange instrument.


The euro has been declining against the dollar over the past decade. In 2008, the euro versus dollar currency pair traded to a high at $1.59880 to the euro. The most recent low came in October 2016 at $1.03675. At the $1.11 level on November 5, the euro remains a lot closer to the low than the high over the past eleven years.


Since interest rate differentials play a significant role in the dollar-euro currency pair, the European Central Bank is a considerable force as it determines monetary policy. Since the 2008 financial crisis, the ECB has not only had a substantial influence on the short-term deposit rate but on rates further out along the yield curve. A changing of the guard at the ECB could eventually have an impact on monetary policy on the other side of the Atlantic Ocean.


The Invesco Currency Shares Euro Currency Trust (FXE) moves higher and lower with the dollar-euro currency pair.


Farewell to Mario Draghi, the ultimate dove


Wim Duisenberg was the first President of the European Central Bank. He remained at the helm of the ECB until November 1, 2003. Under the first leader of the ECB, the value of the euro versus the US dollar increased from parity to $1.1575. Jean-Claude Trichet replaced President Duisenberg. Trichet's eight-year term came to an end on November 1, 2011. He served through the tumultuous period when the global financial crisis gripped markets across all asset classes. Bailouts, negative interest rates, and unprecedented bond buying were the hallmark of Trichet's term. However, when criticized for the level of quantitative easing, he argued the ECB delivered price stability "impeccably." Trichet's term took the euro from $1.1575 to $1.3852.


After a German and French leader at the ECB, the torch passed to Mario from Italy. Draghi was a former managing director at Goldman Sachs, the executive director of the World Bank, the Chairman of the Financial Stability Board, and Governor of the Banca d'Italia. President Draghi's legacy will likely be as the dovish central banker who expanded quantitative easing to cover high-quality corporate as well as sovereign debt. Draghi did not follow the US Fed when it began increasing rates in 2015 and reducing its swollen balance sheet. While he ended QE briefly, President Draghi's last official monetary move was to lower the deposit rate to negative 50 points and restart QE this month to the tune of 20 billion euros per month. Under Mario Draghi, the euro versus the dollar currency pair fell from $1.3852 to $1.11825. President Draghi's addiction to monetary policy accommodation weighed on the value of the euro currency in an attempt to stimulate economic activity within the union.


The era of Lagarde begins


As President Draghi's eight-year term expired at the end of last week, Christine Lagarde from France took over and became the first woman to run the ECB. Lagarde was previously the Minister of Economy, Finance and Industry of France. Most recently, she was the Managing Director of the International Monetary Fund. Her experience at the supranational institution qualifies her to be the second French leader of the ECB.


President Lagarde will serve until October 31, 2027. While most analysts believe President Lagarde will continue to maintain an accommodative approach to monetary policy, she will likely be a more forceful voice as the head of the world's second-leading central bank.


A fresh program of QE greets the new leader


Mario Draghi's gift to the new President was a new low in the short-term deposit rate at negative 50 points. At the same time, he pushed the button to restart bond buying on the day she took over at the head of the central bank.


Last week, in a radio interview, President Lagarde sent a strong message to Germany and other countries within the EU that are running budget surpluses. She told them that they "have not really made the necessary efforts" to consolidate a period of low growth, while the central banks "have done their job."


President Lagarde faces sluggish economic growth in the Eurozone, the Brexit debacle, and the ongoing trade war between the US and China that weighs on the global economy. She is likely to be a more forceful voice advocating for fiscal rather than monetary policy initiatives to jumpstart the European economy. However, the reality of economic weakness and low levels of inflation in Europe could tie her hands over the coming months as she follows in the dovish footsteps of Mr. Draghi. The first issue on the agenda is the potential pitfalls surrounding Brexit. Meanwhile, Southern members of the union have continuously been on the edge of a financial cliff that could lead to more bailouts.


Europe missed the train on U.S. leadership


Europe followed the US into the era of dovish monetary policy following the 2008 global financial crisis. Meanwhile, Europe did not follow the US out. In 2015, the Fed began slowly increasing interest rates. The ECB did not. The Fed reduced its swollen balance sheet to shed the legacy of quantitative easing; the ECB did not. Under the Trump administration, fiscal policy initiatives of tax and regulatory reforms provided stimulus. Europe did not follow the US over the past years. However, when the Fed reversed course and began cutting short-term rates and ended its balance sheet normalization program over recent months, the ECB cut its deposit rate and started buying bonds once again. While the US only bought government bonds during its QE program, Europe expanded QE to cover high-quality corporate issues.


Europe missed the train when it came to making room for future monetary policy accommodation. President Lagarde takes over at a precarious time as the US central bank is now back in dovish mode. At the same time, the 2020 Presidential election in the US could significantly change the policy path when it comes to fiscal stimulus impacting global economic conditions.


The euro currency remains under pressure


Lots of issues are weighing on the value of the euro currency these days. Meanwhile, the interest rate differentials between the dollar and the euro currency continue to make holding dollar more attractive. Even though the Fed cut short-term rates by 75 basis points, the dollar continues to provide a 1.50% to 1.75% positive yield. Holding euros involved assuming a cost of 50 basis points, which is not bullish for the European currency.


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