LONDON, Oct 23 (Reuters) - If Europe’s joint debt sales did lift the euro/dollar exchange rate this week, as some suspect, then the European Central Bank may struggle to keep a lid on the currency in the face of almost 1 trillion euros more of such sales over the next six years.
After surging more than 10% between March and August as economies and markets bounced back from the pandemic shock, the world’s key Transatlantic exchange rate has stalled ever since just below $1.20 per euro.
ECB protests at excessive euro appreciation played a part in warning traders off the currency, although dollar losses were also staunched by a rule of thumb that more U.S. fiscal spending will weaken the greenback. As a result, deadlocked fiscal talks in Washington as the election nears have, in effect, supported the dollar.
But one additional argument for a higher euro/dollar was made this week after a blowout 17-billion-euro European Union bond sale was oversubscribed some 14 times and drew heavy bids from foreign central banks and reserve managers.
The EU raised the cash from the sale of 10 and 20-year “social” bonds, its first joint debt funding for the so-called SURE unemployment relief scheme. The 233 billion euros in bids received was the highest demand for a bond sale ever recorded.
While that bodes well for the rest of the 100-billion-euro SURE scheme through next year, it also tees up 800 billion euros in joint bonds for its post-pandemic Recovery Fund between 2021 and 2026. Such bonds are a godsend for funds desperate for paper badged Environmental, Social and Governance compliant.
In the trading sessions surrounding Tuesday’s deal, euro/dollar climbed a cumulative 1.4% even as governments across the continent ramped up restrictions amid a swelling second wave of the pandemic. Some banks, including Morgan Stanley, said positivity surrounding the deal may have helped the euro higher but doubted any long-term effect as buyers would likely sell the bonds on to the ECB at a later date.
But Deutsche Bank currency strategist George Saravelos reckons unusually high demand from central bank reserve managers for the 10-year issue was significant. Their 37% share of the sale was almost twice that of previous such issues, he said, and these bonds would be bought to hold.
“Central banks are usually unhedged investors so strong demand for a bond means direct demand for euro/dollar,” Saravelos argued. And “it signals a vote of confidence on the euro as a reserve asset, particularly at a time when the dollar’s dominant role is being questioned”. “Europe has just started to provide a new investment destination for reserves looking for a home.”
A long-standing dollar bear, Saravelos reckons the U.S. currency has much further to sink as the Federal Reserve soaks up more fiscal spending next year stateside via bond-buying and the U.S. trade deficit expands to new records.
With Asian economies such as China or South Korea building much of the surpluses that mirror the U.S. deficit, and also leading a post-pandemic economic recovery, the dollar is falling fastest there - seen in the yuan surge to two-year highs this week.
Likely intervention by those central banks, to buy dollars to rein in their own currencies, will lead to more dollar-reserve accumulation, says Saravelos. These then get partly diversified to euros in turn - often banked in European bonds, he adds.
But if the euro gets this sort of lift from central bank activity in a bond sale of just 17 billion euros, then there are big questions about what may happen if that’s replicated through hundreds of billions of euros of sales over the years ahead.
There are caveats. Central bank take-up was far less in the 20-year sale, probably as reserve managers tend to avoid such long-term debt. There’s also no guarantee their participation will be as high going forward and some will just replace other AAA euro bonds such as German bunds with the EU joint paper.
The ECB, which meets next week and has already stressed the importance of the exchange rate in its inflation and economic goals, will probably see the fiscal action requiring the debt sales as the overwhelming priority and euro gains an irritating spillover.
But repeated comments from President Christine Lagarde and chief economist Philip Lane in recent weeks left markets in no doubt about ECB sensitivity to further euro appreciation - not least with its 2022 inflation forecast of 1.3%, far below target and made even before a second wave of the virus hit hard.
The ECB has many much more pressing economic reasons to step up its monetary easing further - and possibly even cut its already negative policy rate again. But the euro is likely an important factor in there as the inflation horizon darkens.
Estimating that the Fed’s balance sheet expanded 16 percentage points more than the ECB’s since March, a research paper released on the ECB website this week said that the disparity in bond buys likely accounted for 6% of euro/dollar’s 10% rise between March and September.
The ECB board will know that well.