Euro’s Strength May Impact ECB Policy Decisions
Dec 9 – The euro’s current strength is accentuating deflationary pressures on China’s export sector and could eventually lead the European Central Bank (ECB) to reconsider its position, possibly resulting in further interest rate cuts.
Presently, the euro stands at about $1.166, reaching a four-year peak of $1.1918 in September, and is projected to appreciate nearly 13% this year—its most significant annual increase since 2017.
Evaluating the True Value of the Euro
As of September, the ECB’s real effective exchange rate for the euro—an inflation-adjusted average against major trading partner currencies—hit 98.68, a level not seen since May 2014. In November, it recorded 97.81.
The nominal interest rate is approximately 129.96 but peaked at 130.87 in September, forecasted to rise 5.7% through 2025.
“The euro is far more expensive than it appears,” suggested Themos Fiotakis, Barclays’ global head of foreign exchange strategy.
He noted comparisons against other currencies reveal the euro is at a historically elevated level, and when considering U.S. tariffs, its effective rate might align closer to $1.28.
A significant factor in the euro’s rise is the 7% drop in the Chinese yuan in offshore markets this year.
China remains Europe’s top trading partner; recent figures indicate the eurozone’s trade deficit with China stood at 33 billion euros in September, contrasting sharply with a 22.2 billion euro surplus with the U.S., the region’s second-largest partner.
Potential for Rate Cuts
Goldman Sachs has adjusted its growth forecasts for China, citing that Beijing’s tactic of saturating markets with inexpensive goods might instigate deflation, particularly affecting Europe.
Chinese exporters are likely to target markets beyond the U.S., with limited chances for trade barriers due to China’s dominance in essential rare earth materials.
In July, ECB Vice-President Luis Deguindos acknowledged that while the bank could overlook the euro’s strength up to $1.20, scenarios exceeding this threshold could complicate matters significantly.
“Currently, the exchange rate pass-through appears limited as margins are still being adjusted, and that process may be ongoing,” John Wells, chief European economist at HSBC, stated.
He added that a sharp increase in the trade-weighted euro—around 5%—could likely lead to additional policy easing, suggesting potential for multiple interest rate reductions.
In September, ECB official Martin Kocher stated that while the exchange rate wasn’t a concern, further appreciation of the euro could pose challenges for exporters. Martins Kazaks echoed this sentiment, emphasizing that the exchange rate and trade flows with China are crucial factors influencing the central bank’s policy outlook.
“My advice to clients is that while the base case includes unchanged rates, it’s still probable that the ECB will reduce rates one or two more times before next summer,” Carsten Brzeski, global head of macro research and chief euro area economist at ING noted.
“The situation in China could serve as a tipping point for the ECB to implement rate cuts.”
Market Expectations for ECB Rate Changes
Market traders anticipate the ECB will maintain its current stance until at least March 2027, though worries over tariffs and a global trade conflict have helped recovery from an April low of 1.55% experienced after tariffs were imposed by President Trump on several trading partners.
Analysts suggest the euro’s future will largely depend on the interest rate differentials between the eurozone and the United States. The Federal Reserve is widely expected to cut rates next year, which could weaken the dollar and, in turn, uplift the euro.
“Lower interest rates typically correlate with a weaker dollar,” explained Andreas Koenig, head of global currency management at Amundi Asset Management, suggesting that Trump may encourage further Fed easing as midterm elections approach.
“I think we’ll see a weaker dollar first, followed by an uptick in the U.S. economy.”
