No Letup in Europe’s Currency Battles

No Letup in Europe’s Currency Battles

RICHARD BARLEY

Jan. 5, 2014 4:19 p.m. ET

The currency wars that Brazilian Finance Minister Guido Mantega first warned of in 2010 have never quite reached a boiling point. But currency skirmishes are certainly under way as unprecedented loose global monetary policy continues to reverberate through markets.In Europe, both the euro and the Turkish lira, and the headaches they pose for their respective central banks, are testament to that.

The first trading day of 2014 brought some relief for the European Central Bank, as the euro recorded its sharpest one-day decline against the dollar since November. The single currency hit a two-year high above $1.38 as 2013 closed, sparking worries about its impact on growth and inflation.

But the new year brought increased pain for the lira, which hit a record low of 2.18 liras to the dollar, making central bank Gov. Erdem Basci’s promise last year to defend the currency “like a lion” sound hollow.

Both currencies have been affected perhaps as much by U.S. monetary policy as by domestic developments, albeit in different ways.

Emerging-market currencies like the Turkish lira were hit hard when the Federal Reserve started talking in May about winding down its bond purchases. Turkey suffered in particular due to its wide current-account deficit.

Meanwhile, even as the Fed was talking about tapering, it was still perceived as more willing to undertake radical action than the ECB, which was seeing its balance sheet shrink as banks repaid loans. Coupled with an improvement in the euro-zone outlook that drew investors back to European markets, that pushed the euro higher against the dollar in the second half of 2013.

The problems for the euro and lira could yet persist. Even with the Fed now tapering its bond purchases, the euro has strong underpinnings. The euro zone runs a current-account surplus, and European assets may still draw more inflows.

Two things could make a difference. One would be if short-term U.S. and German government-bond yields were to diverge markedly. That might happen if the debate in the U.S. focuses more on when the Fed might start raising rates; higher U.S. yields would support the dollar. But the two-year U.S.-German yield difference, or spread, has been range-bound since July.

The second would require the ECB to put its money where its mouth is and actively loosen policy. But the ECB may be reluctant to undertake more unorthodox measures. As a result, the euro, while it may not rally much further from here, may not decisively weaken either.

For the lira, the answer seems more clear-cut: Turkey’s central bank needs to raise rates, rather than persisting with small-scale interventions. But with an election due and political scandal testing the government, it isn’t clear whether a rate increase is in the cards.

True, the euro is now looking expensive to some, while the lira looks oversold. But investors will likely have to rely on central banks to provide the ammunition to turn the tide in these currency battles.