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Eurozone: dreadful politics but improving economics make bullish case for EUR/USD

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26 th January 2017
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There have been reports that banks, fearful of a breakdown in the euro, are seeking to balance assets and liabilities by member state – in order to avoid the potential calamitous outcome of, for example, Italian assets and German liabilities at a time of stress. This makes perfect sense, for the euro is indeed facing another period of potential instability. 

There is an understandable focus on the forthcoming elections in the Netherlands, where Geert Wilders’ Freedom Party enjoys a nine-point poll lead over Mark Rutte’s conservatives, who are themselves moving rapidly to the right on immigration in an attempt to stem the populist tide. After the Dutch election on 15 March, markets will have to contend with the French Presidential election on 23 April, where Marine Le Pen is expected to make the second round on 7 May but go no further. Le Pen is unlikely to win, although pundits must exercise extreme caution after the UK’s vote for Brexit and the election of President Trump.

It may be premature to talk of a breakdown in the euro but banks are surely correct to be balancing their assets and liabilities. One of the problems of hedging the euro is that its composition a year or two down the line is unknown. Should populism prevail in France or Italy, and the Southern states leave the euro to the Northern core, what would remain of the single currency would look more like the Deutsche Mark and strengthen accordingly.

On the other hand, there is a respectable line of economic reasoning that argues that Germany, with its massive current account surplus, is the problem. Rather than punishing the weaker member states with endless austerity and deflation in an attempt to restore competitiveness, it is argued that it is Germany that should leave the euro, allowing it to depreciate and conferring relief on the likes of Italy and Spain.

In such a scenario, the euro would be considerably weaker. The point is that whether the euro is set to resemble a Deutsche Mark or an Italian Lira is currently unknowable. However, the currency on which Germany eventually settles will be strong, while the currency (or currencies) adopted by Southern Europe will be weaker.

Should tensions rise, German banks will increasingly enjoy inflows of deposits while Southern Europe will experience just the opposite. Furthermore, the flames of the booming German housing market will be further fanned by the capital influx. This is unlikely to prove anything other than inflationary for the German economy, where inflation is already running at an alarming (by German standards) 1.7%.

It was quite clear from Mario Draghi’s comments at the ECB press conference last Thursday that he is prepared to ignore German inflation in the short term, exhorting savers to be patient as they await higher rates. The problem is that with eurozone core inflation at only 0.9%, savers in Germany and elsewhere may have to wait an uncomfortably long time. In the meantime, in the face of continued ECB inaction and rising inflation, real interest rates in Germany will continue to fall, encouraging even the famously risk-averse Germans to invest in hard assets like property.

The potential for this has existed for years, but the deflationary forces after the Great Recession kept inflation suppressed and real interest rates higher. In this period, Germany was assisted by its relatively undervalued currency. Now that the deflationary forces are dissipating, the effects of Germany’s undervalued currency are suddenly laid bare. In effect, the euro and its one-size-fits-all eurozone monetary policy created contra-cyclical stimulus for Germany when it needed it. Unfortunately, the same currency and monetary policy are now providing unwanted pro-cyclical stimulus.

Yesterday saw the release of eurozone PMI data. Manufacturing came in slightly stronger than expected at 55.1, while the services number was slightly weaker than expected at 53.6, despite a strong performance from France, which recorded 53.9, up from last month’s 52.9 and against expectations of 53.2. Meanwhile, this morning, Italy released stronger-than-expected industrial orders data for November – up 1.5% month on month compared with 0.9% in October and up 0.1% year on year, compared to October’s minus 3.2%. Whisper it, but the eurozone’s economic performance is steadily improving, despite being unbalanced with Germany running too hot. If the ECB is to continue with ultra-loose monetary policy for a while yet, a stronger euro, particularly against the dollar, would help rein in Germany’s inflation problem. With so many market participants still looking for a stronger dollar, such an upward move in EUR/USD, wrong-footing the market, would come as no surprise.    
 

All views expressed here are the author’s own and are based on information available at the time of writing.

 

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