The Overview of Euro (EUR)
The European Union developed as an institutional system for the construction of a unified Europe. The E.U. currently consists of Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden, Hungary, Slovakia, Lithuania, Latvia, Estonia, Slovenia, Cyprus, Bulgaria, Romania, and Croatia (including the United Kingdom). Countries except Denmark, Sweden, the United Kingdom, the Czech Republic, Hungary, Poland, Lithuania, Bulgaria, Romania, and Croatia use the Euro as their common currency.
The 18 countries that use the common currency by organising the European Monetary Union (EMU) and share the single monetary policy required by the European Central Bank (ECB). The EMU is the world’s second-largest economy with a highly developed bond market, stock market and futures market. EMU is becoming the second most attractive investment market for investors both inside and outside the Euro area.
The Euro has taken its place, and more countries participate in the EMU. The importance of the euro as a reserve currency has increased at the same time, thereby increasing the inflow of capital into Europe. Euro’s demand is expected to continue to grow as foreign central banks are expected to increase their euro holdings to diversify their portfolio in the future.
EMU is a trade-driven and capital flow-driven economy. Therefore, trade is significant for each country within the EMU. Unlike most significant economies, EMU does not incur large-scale trade deficit surpluses. Yet, EMU also has considerable trade volume with other countries, so it has great power in international trade. The formation of the EU has also increased its influence in the international community. If individual countries are integrated into a single economic bloc, they can negotiate on an equal footing with the United States, the largest trading partner.
The growing role of the EU in international trade has given significant meaning to the part of the euro as a reserve currency. To reduce exchange risk and transaction costs, countries should have a large amount of reserve currency. Traditionally, most international trade deals have used British pounds, Japanese yen, and U.S. dollars. Before introducing the euro, it was entirely unreasonable for European countries to hold the currencies of other European countries on a large scale. Hence, the bank had the reserve currency in dollars.
European Central Bank(ECB)
Determines Monetary Policy
ECB is the organisation responsible for determining the monetary policy of the EMU participating countries. The EMU’s executive committee form a policy with central bank governors from each country and implement policies. At bi-weekly meetings, the new monetary policy is usually decided by a majority vote, and if the polls are tied, the president will have the right to choose.
EMU’s primary goals are to stabilise prices and promote growth. Changes in monetary and fiscal policy are made to achieve these goals. The EU enacted the Maastricht Treaty, which established several application criteria for individual countries to achieve that goal. Any country that deviates from these standards will be subject to hefty fines.
Based on these criteria, the ECB has strict membership management rights focused on inflation and deficits. The ECB typically strives to maintain the monthly consumer price index, harmonised Index of consumer prices(HICP), at less than 2% per year and M3 (currency supply) at 4.5% per year.
EMU Convergence Criteria
The 1992 Treaty of Maastricht defined the following prerequisites for membership in the European Monetary Union (EMU).
1. Inflation should not exceed 1.5% of the average annual inflation before the evaluation date of the three countries with the best economic conditions in the region.
2. Long-term interest rates will not exceed the 12-month average of the three countries with the lowest inflation rate of any country in the region (10 years).
3. The exchange rate will remain within the range of exchange rate fluctuation (15% above and below the benchmark rate) of the ERM (EXCHANGE-RATE MECHANISM) for at least 2 years.
4. General government debt balances should remain within 60% of GDP. If higher than this, allow if it is decreasing sufficiently.
5. General financial deficits should remain within 3% of GDP. Allow temporary or slight excess.
ESCB, ECB and 28 member central banks are independent of governments and other EU agencies and have complete control over monetary policy. Members granted this operational independence under Article 108 of the Treaty of Maastricht. The main content of Article 108 states that members of a decision-making organisation cannot receive instructions from local, government, or any other organisation in the EU.
Open Market Manipulation
The ECB is operating open markets in four categories to adjust interest rates, manage liquidity and suggest monetary policy stance:
1. Main Refinancing Operation(MRO)
→ It is a two-week liquidity supply (loan) program implemented every week and is a refinancing transaction to the financial sector.
2. Longer-Term Refinancing Operation(LTRO)
→ Long-term refinancing is provided to the financial sector as a liquidity supply (loan) program with a maturity of more than three months, which is implemented once a month.
3. Fine-Tuning Operation
→ Policies implemented from time to time to manage liquidity in the market and adjust interest rates are implemented to control interest rate fluctuations arising from unforeseen changes in liquidity.
4. Structural Manipulation
→ This includes issuing debt instruments, redemption transactions, and outline transactions. Manipulation occurs when ECB wants to adjust the euro system’s structural position in the financial sector (regular or irregular).
ECB Minimum Bid Rate
The lowest bid rate for the European Central Bank is an important policy objective. It is directly related to a loan rate provided to the central bank of the various countries. The rate is adjusted every 2weeks, and ECB tends to keep interest rates to the targeted rate to prevent inflation.
The ECB is not reducing its exchange rate target, but it will consider the exchange rate in the policy deliberation process as it affects price stability. Consequently, the ECB implements foreign exchange market intervention in the event of inflation.
As a result, the policy committee members’ remarks draw attention to foreign exchange market participants and trigger euro volatility. The ECB publishes monthly data describing economic growth analysis and changes in perception of economic conditions, which need to be watched because it can detect the change in monetary policy stance.
Key Characteristics of the Euro
1. EUR/USD is the most volatile currency, and all major euro-cross currencies are also highly volatile.
The euro debuted on 1 January 1999 in the form of electronic currency. At that time, the euro replaced all pre-EMU currencies. As a result, EUR/USD is currently the most fluid currency pair globally, and the movement of EUR/USD is used as a primary measure of European and U.S. economic health. The euro is commonly known as the “anti-dollar” because it was the dollar’s fundamentals that influenced the EUR/USD currency pair movement between 2003 and 2008.
EUR/JPY and EUR/CHF are also highly volatile currencies and are commonly used to determine Japanese and Swiss economies’ health. EUR/USD and EUR/GBP are good pairs of currencies to trade because of their low spread, orderly movement, and infrequent gaps.
2. The euro has unique risks.
Introduced in 1999, the euro is still a new currency. The euro is not a problem for other currencies, but there are many risks to consider. In other words, 28 countries are exposed to economic, political and social situations. Although the number of countries using the euro is expected to increase, it will affect the stability of the entire eurozone if any country stops using the euro or begins to return to its currency because it does not think the ECB’s policy is in its best interest.
The euro is the only currency in the world that is not used on a national basis. Even if Germany, France, Italy and Spain are the largest and most economically dominant countries in the eurozone, the ECB has the authority and responsibility to determine monetary policy for all 28 member states. The 28 member states frequently verify, criticise and politically press the ECB’s actions. Before the subprime crisis, the ECB was just a new, untested central bank. However, the ECB has wholly changed its reputation for them by responding quickly to the credit crunch and providing ample liquidity.
3. The spread of interest rates between 10-year U.S. government bonds and 10-year German government bonds suggests a euro direction.
The 10-year government bond is used as an essential indicator of the future euro exchange rate. The difference in interest rates between the 10-year U.S. and 10-year German government bonds is a good sign for the euro. If German government bond interest rates are higher than those of U.S. government bonds, and the difference increases or the spread widens, this suggests a rise in the euro. If the difference in interest rates decreases or the spread narrows, the euro can be predicted to fall. The 10-year German government bond is usually used as the eurozone’s benchmark bond.
4. Forecasting the flow of funds in the euro area.
Another trading indicator is the Inter-European bank rate (three-month interest rate), a regular deposit rate between large banks. Traders tend to compare the eurodollar futures rate with the three-month interest rate to forecast the movement.
M&A also have significant implications for EUR/USD movements. M&A between EU and US multinational corporations has been increasing in recent years. The large transactions will have a significant short-term impact on EUR/USD.
An Important Economic Indicator of the Euro
The following are all important economic indicators for the euro. It is also essential to be aware of political and economic situations such as GDP, inflation, and unemployment. The leading economies of the European Monetary Union (EMU) are Germany, France and Italy. Therefore, we should note the economic indicators of the above three countries, along with the overall EMU economic indicators.
1. GDP
GDP is collected and published by Eurostat from many countries. It usually includes France, Germany, and the Netherlands (Italy only added to the final report). The annual total of EU-28 and EMU-18 is a simple sum of national GDP. It is more complicated to add up because some countries (Greece, Ireland, Luxembourg) do not create quarterly national data. Moreover, Portugal produces partial quarterly figures with significant time differences. Thus, quarterly figures across EU-28 and EMU-18 are estimates based on groups of countries that account for more than 95% of the total EU GDP.
2. German Industrial Production
Industrial production includes a breakdown of four segments (mining, manufacturing, energy and construction) reflecting seasonal factors. Manufacturing production consists of four main product groups: necessary production materials, capital goods, consumer goods and non-durable consumer goods.
Since Germany is the largest economy in the eurozone, industrial production in Germany is significant. However, markets sometimes react to French industrial production. Because industrial production has fewer data samples, modifications using all models are used as valid data. The Treasury often displays the expected direction of the changes in the initial data.
3. Harmonized Consumer price index (HICP)
The EU HICP, announced by Eurostat, was designed for national comparative analysis based on EU law. Eurostat has published the index since January 1995, and since January 1998, it has published the EMU-18 Regional Detail Index, called the MUICP. Price information provides Euro start with 100 indexes for each national statistical agency to survey and calculate their harmonised consumer price index.
Eurostat aggregates these sub-indexes into weighted averages and publishes each country’s harmonised consumer price index, which is then weighted by country and releases at the end of every month. It is around ten days after the announcement of the national CPI in Spain, France and EMU-5 countries.
Although the market already reflects prices when the harmonised consumer price index is released, it is worth noting that the ECB references the index. The ECB aims to maintain consumer price inflation in the euro area within 0% to 2%.
4. M3
M3 is a broad money supply indicator that includes both bonds and bank deposits. The ECB closely observes M3 inflation as its primary measure. In December 1998, the ECB’s Policy Committee set the M3 target at 4.5%, achieving the inflation target of 2%, the growth target of 2 to 2.5%, and the long-term monetary rate target of 0.5 to 1%. Growth rates are observed on a three-month moving average basis to avoid possible information distortions in monthly variability.
The ECB’s approach to monetary goals has room for manipulation and intervention. As the German central bank did, the ECB does not set the scope of M3, so there will be no action even if M3 is outside the set range. Furthermore, although the ECB considers M3 an important indicator, it will also refer to other changes in the direction of currency circulation.
5. German Unemployment Rate
The unemployment rate announced by the Federal Labor Office in Germany both seasonally adjusted (SA) and non-seasonally adjusted (NSA) figures, including information on the unemployed population. Unseasonably adjusted unemployment rates are announced along with vacancies, short-term shifts, and the number of employees.
Germany’s central bank announces seasonally adjusted unemployment within an hour of the Federal Labor Office announcement. A day before the announcement, official data is often leaked from the labour union, when the number of unseasonably adjusted unemployed is almost millions.
When sources in Reuters report the offensive numbers of unseasonably adjusted unemployment, the leaked figures usually reflect official statistics. Rumours are sometimes circulated a week before the official announcement, but they are wildly inaccurate. Furthermore, German statements have been misinterpreted through foreign media so far, so caution is needed in interpreting rumours.
6. Each Country’s Fiscal Deficit
The stability and growth pact sets the upper limit of the fiscal deficit below 3% GDP. Each country also has goals to reduce its fiscal deficit. Market participants keep an eye on whether they fall short of the target.
7. IFO Survey
Germany, which accounts for more than 30% of the eurozone’s GDP, is Europe’s largest economy. Thus, an understanding of the status of German companies is regarded as this issue for the whole of Europe. IFO investigates the German corporate environment and short-term planning for 7,000 German companies every month.