EUR Rally Will Hit The Buffers


Short-Term Outlook: Having hit an inflexion point in early 2013, the euro continues to defy gravity as passive monetary tightening and a current account surplus have kept the beleaguered single currency well above its long-term average. Indeed, despite the weak economic outlook and lack of structural reforms which pose a serious risk to systemic stability, the euro continues to grind higher. Currently trading at US$1.38/EUR, we believe that further passive monetary tightening and appetite among foreign investors for European assets will nude the euro towards US$1.40/EUR in the short term.

Core View: Despite long being medium-term bearish the euro, we turned tactically bullish in early 2013 given the aforementioned monetary policy and current account dynamics, as well as our assumption that extremely bearish investor sentiment would naturally pare back as the financial market turmoil of 2012 gave way to a more stable environment in 2013. Moreover, we believed that these dynamics would persist in the early part of 2014, keeping the euro strong, but would eventually give way to weak economic fundamentals and further monetary easing. We have now gone a step further and have argued that now is a good time to return to our fundamental bearish EUR view (see Time To Turn Bearish The EUR, April 14). This is not so much an expectation of an immediate EUR reversal, but rather that the rally is drawing to a close. Even if the euro were to continue strengthen from this point, this alone would suggest that economic growth would be adversely affected and that the European Central Bank would be pushed into further monetary easing.

The economic trajectories and monetary policy cycles of the US and UK compared with the eurozone are drifting further apart and will appear even more stark towards the end of 2014 as speculation will continue to build that the Federal Reserve and Bank of England will be close to hiking interest rates. Indeed, given that the US economy is continuing to power along at a robust clip, and the UK economy is set to be one of the fastest growing among developed states this year, spare capacity in both cases is being rapidly absorbed which will provide scope for the Fed and BoE to begin normalising policy. The eurozone, meanwhile, is only just limping out of recession, with the pace of growth set to remain anaemic over the medium term. With headline inflation now also perilously low at 0.5% y-o-y in March, the European Central Bank (ECB) is coming under increasing pressure to ease policy. That ECB President Mario Draghi has directly linked recent weak inflation prints with the ongoing strength of the euro is particularly pertinent in our view.

EUR Rally Will Lose Steam
Eurozone - Exchange Rate, US$/EUR

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Sector: Country Risk