The strength of the euro is a sign that the European Central Bank is not doing enough to pump up stubbornly low inflation, investors say, highlighting how a rising currency could become an increasingly heavy burden for policymakers.

Despite a small pullback in January, the euro stands almost 9 per cent stronger against the dollar now than it did a year ago. The euro’s strength is not merely a reflection of a weak US dollar: it has also gained against the pound and a host of emerging market currencies.

The rally poses a challenge to the ECB. It could hamper exporters at a delicate time for the region’s economic recovery from coronavirus. But it also highlights the limits of the central bank’s ability to meet its mandate. Not only has the eurozone experienced five consecutive months of falling prices, but long-term inflation expectations remain far below the ECB’s target of close to 2 per cent.

“Ordinarily you would see low inflation cause a currency to fall,” said Robin Brooks, chief economist at the Institute of International Finance. “But that’s only if markets expect the central bank to respond, and right now the ECB is not getting the memo.”

The ECB has unleashed unprecedented efforts to tackle the effects of coronavirus since March, including a €1.85tn programme of asset purchases. But despite the central bank’s success in taming a financial market crisis, these measures have failed to remedy the bloc’s chronic low inflation problem.

Line chart of $ per € showing Euro strengthens during pandemic as inflation remains stubbornly low

Sticky euro strength shows markets think the ECB will not cut interest rates again, or at least cannot cut them by much. Meanwhile, though bond purchases hold down long-term yields there is little scope to lower them further.

That means real yields — long-term interest rates adjusted for expected inflation — have not fallen during the pandemic, in contrast to a dramatic drop in the US. Relatively buoyant real yields make euro assets more attractive to investors, boosting the currency. Germany’s 10-year real yield, a reference for the euro area, currently trades at minus 1.6 per cent, roughly where it did a year ago. While they remain higher at just above minus 1 per cent, US 10-year real yields have plunged by almost a whole percentage point over the same period.

The relationship between currency strength and deflation can become mutually reinforcing, as a strong currency chips away at import prices, muffling inflation. Mr Brooks likens the ECB’s predicament to that of the Bank of Japan in the wake of the financial crisis, when a disinflationary outlook boosted the yen, in turn further fuelling fears of deflation. The only way to break this vicious cycle is with much more aggressive monetary easing, with even larger asset purchases the best tool, according to Mr Brooks.

The ECB’s problem is that it has been left behind by more aggressive central banks — notably the Federal Reserve, which has slashed interest rates and bought up bonds at an even faster pace.

Line chart of 5y5y forward inflation swaps (%) showing Inflation expectations rebound faster in US than eurozone

“In currencies it’s the relative game that matters,” said Salman Ahmed, global head of macro at Fidelity International. “You can argue that the ECB has been very aggressive in its policy, but has it been more aggressive than others. If the ECB wants to get the euro down, they will have to outgun the Fed — there’s no other way.”

Mr Ahmed said the ECB could further tame the euro by dropping hints at its meeting on Thursday that cuts in interest rates are a possibility.

ECB officials have previously signalled their alarm at the euro’s strength, and it remains “extremely attentive” to the impact of the stronger euro on inflation, president Christine Lagarde said last week. More than half of the 33 economists polled by the FT last month said they expected the euro to continue rising against the dollar this year, while most of the others said they expected it to stay at current levels. Only two expect it to fall.

But if it wants to shift market expectations for future price rises, the central bank will have a job on its hands, fund managers say.

“The inflation trajectory remains bleak,” said Konstantin Veit, a portfolio manager at Pimco. According to its own projections, the ECB is set to miss its target by some distance for the next three years, raising the possibility of a “Japanese style de-anchoring of inflation expectations in the euro area,” he added.

Some analysts say the level of the euro — particularly given its more than 1 per cent January dip — is not yet sufficiently high to set alarm bells ringing in Frankfurt.

“The view from the ECB will be that a stronger currency is overwhelmingly the product of a rebound in growth expectations,” said Frederik Ducrozet, an economist at Pictet Wealth Management. “If we get to $1.30, that’s a different story, but I think they’ll be comfortable where they are.”

The common currency traded just below $1.21 on Monday.

For many investors the ECB’s apparent powerlessness to bring down real interest rates or bond yields is a green light for further currency appreciation, particularly in a world where most analysts are expecting further dollar weakness as growth stirs in the US. There is considerable scepticism in markets about whether more aggressive ECB easing would make much impact on inflation expectations, given previous rounds have done little to shift them higher.

Even so, further currency strength could force the ECB to give it a try.

“With the euro, we are talking about a currency that’s becoming a deflationary currency,” said Mr Ahmed. “And we are close to the level where this is becoming painful.”

Additional reporting by Martin Arnold