London - A year after the European Central Bank pledged to do all it could to save the euro, the currency's new-found strength is tangling with its efforts to keep euro zone monetary policy loose.
When ECB President Mario Draghi said last week the central bank stood ready to offer more long-term loans to banks to keep money-market rates from rising, some in the market saw it as a covert - and misguided - attempt to talk down the euro.
With the euro near a two-year high on a trade-weighted basis, traders expect more such talk, but not much impact on the currency. The euro remains supported by an improving economy, the ECB's 2012 promise to save it, and the US Federal Reserve's decision last week to leave its monetary stimulus programme unchanged.
“The ECB won't welcome either the strength of the euro or the push higher in market rates. I think they will step up the rhetoric,” said Rabobank senior currency strategist Jane Foley.
“This year is different to previous years. We can talk about real euro resilience.”
The ECB issued unprecedented “forward guidance” to curb a rise in money market rates in July, saying interest rates would stay low for a prolonged period.
That policy was unveiled when the prospect of the Fed slowing the pace of its bond-buying stimulus was pushing money-market rates higher.
But paradoxically, Draghi's hint at the prospect of more cheap loans came days after the Fed's surprise decision drove euro zone money market rates to six-week lows.
That led some analysts to believe he may this time have had the euro's strength in mind, because the Fed decision pushed the euro to an eight-month high against the dollar.
“There is a lack of any direct reference by Draghi (to the euro) ... What you do get is indirect comments the market interprets as a very veiled, latent concern that the euro can get too high and too expensive,” said Neil Jones, head of hedge fund FX sales at Mizuho.
The euro rose to $1.3569 after the Fed left its monetary policy unchanged on September 19. On Tuesday, a political stalemate that partially shut down the US government pushed it to $1.3589.
A stronger euro is unwelcome to the central bank because it can hurt exports, potentially threatening the euro zone's nascent recovery. A strong currency and higher money-market rates both effectively tighten financial conditions.
“At $1.35 and possibly drifting towards $1.40, the market's interpretation is this is an amber light on currency concern,” Jones said.
Draghi is likely to expand on his recent comments at a news conference on Wednesday after an ECB policy meeting.
A Reuters poll shows economists expect the ECB to conduct another long-term refinancing operation (LTRO) for banks at the end of this year or early next.
It made more than a trillion euros in cheap loans available in late 2011 and early 2012, most of it now repaid.
But any attempt by the ECB to curb a rise in money-market rates and the euro will be complicated and overshadowed by US monetary policy, analysts say.
The Fed's decision to delay tapering its stimulus has at the same time helped and hindered the ECB's attempts to keep euro zone monetary policy loose, since it pushed money market rates lower but boosted the euro.
And as soon as investors think tapering is back on the table, that would push the euro lower, as investors buy dollars, but would probably cause euro zone money market rates to rise, even if euro zone policy remained accommodative.
Salman Ahmed, global fixed-income strategist at Lombard Odier, said using the LTRO as a monetary policy rather than a crisis-fighting tool was misguided.
“The sensitivity of money markets to these policy measures starts to fall when rates are this low. The first LTRO had a huge impact because the rates were very high and it was targeted towards the banking sector.”
Indeed, for the ECB to have maximum effect both on the euro and on euro zone money markets, some analysts say the ECB should time its LTRO to coincide with the Fed scaling back its stimulus.
That way, the LTRO could curb any rise in euro zone money market rates stemming from the Fed action, which would push the euro lower as the dollar rose.
“They (the ECB) want to build a perception in the market that the ECB has something to set against any rise in front-end rates, especially when tapering speculation should become more acute going forward into Q4,” said Commerzbank strategist Benjamin Schroeder. - Reuters