The euro crossed the symbolic threshold of 1.20 dollars on Tuesday before returning to 1.1840 dollars on Wednesday, down 0.8%.

After the fall in the price index in August, the markets are pointing to the risk of deflation and a Japanese-style scenario.

Investors anticipate a reaction, at least verbal, from the ECB at its next meeting.

The euro exceeded the symbolic threshold of 1.20 dollars on Tuesday, at 1.2011 dollars, to return to 1.1840 dollars on Wednesday, down 0.8%. Since the start of the year, it has gained 5.3% against the greenback, and 4.3% overall, against the currencies of its main trading partners.

The rise in the euro since the end of March from 1.07 to 1.18 dollars “was caused by speculative flows and is not based on European economic fundamentals. The European currency will soon catch up with reality (recession) and go down,” predicts David Bloom, head of FX research at HSBC. “When European interest rates can no longer fall much, it is normally the turn of the euro to take over and retreat to loosen financial conditions. The European Central Bank (ECB) could refer more to the harmful rise of the euro, as it had done from the end of 2017 to the beginning of 2018 when the European currency had progressed too much for its taste.

“A sign of confidence”

The evolution of the euro prompted initial cautious statements from members of the ECB, in accordance with its historic restraint when it expresses itself on its currency. Philip Lane, the chief economist of the ECB, recalled that the “ECB does not target a level of the exchange rate, but the euro-dollar has its importance”. Isabel Schnabel, a member of the ECB's executive board, sees the strength of the euro as “a sign of confidence”. The overall exchange rate of the single currency against the currencies of its trading partners is just 1% below its all-time high reached in October 2009.

During its meeting on September 10, the ECB could mention “an unjustified tightening of financial conditions” caused by the rise in the euro. "An appreciation of the euro's exchange rate leads to a tightening of financial conditions insofar as it lowers inflation (through imports) and increases the real interest rate", underlines the Banque de France.

The strength of the European currency is a warning sign for some economists. "The markets judge that the ECB does not take seriously the risk of deflation and that its policy of support since the crisis is insufficient," said Robin Brooks, chief economist of the Institute of International Finance. In August, consumer prices fell for the first time since 2016 (-0.2% over 1 year). Markets expect long-term inflation of 1.2% in the eurozone, well below the ECB's 2% target.

In 2008, the Bank of Japan underestimated the risk of deflation, which caused the yen to rise sharply. The Japanese currency only fell from 2013. In the coronavirus crisis, the euro zone is facing a "Japanese-style" scenario and the euro could thus continue to rise to around 1.25 dollars, according to Robin Brooks, if the ECB does not take further drastic measures to bring inflation back up. According to Goldman Sachs, a 10% rise in the euro causes gross domestic product and inflation to fall by 1% within two years. The American bank forecasts a level of 1.25 dollars within twelve months.

On Twitter, Frederik Ducrozet, economist and strategist at Pictet Wealth Management, believes that to bring inflation in the euro zone back to its trend level of 2%, the ECB would have to tolerate a significant price slippage from 3.3% to 6 % for several years. What give cold sweats to the hawks of the central bank, supporters of zero tolerance on inflation, and stir up differences within the issuing institute. The US Federal Reserve decided last week to tolerate occasional surges in inflation beyond its 2% target. It is not certain that it will be imitated immediately on this side of the Atlantic.