EUR: Monetary Policy Decoupling Will Weaken The Euro

Short-Term Outlook:

Since turning tactically bullish the euro in early 2013, the single currency has held remarkably firm on a trade weighted basis and is trading above the 15-year average against the US dollar (US$1.22/EUR). As we highlighted at the time, the beleaguered euro is being bolstered by passive monetary tightening at the European Central Bank, a current account returning to surplus and foreign demand for undervalued European assets. More recently we have argued that these dynamics will continue to prop up the euro in the early stages of 2014. Even if the euro pulls back from resistance at US$1.38/EUR, we would still expect the currency to hold firm in the US$1.34-1.38/EUR range in the near term.

Core View:

Flirting With Resistance
Eurozone - US$/EUR
BMI Eurozone Currency Forecast
Spot 2014 2015
US$/EUR 1.37 1.31 1.25
EUR/GBP 1.21 1.21 1.29
Spot Rate, % 0.25 0.25 0.25
Source: BMI, Bloomberg, 19 February 2014

Short-Term Outlook:

Since turning tactically bullish the euro in early 2013, the single currency has held remarkably firm on a trade weighted basis and is trading above the 15-year average against the US dollar (US$1.22/EUR). As we highlighted at the time, the beleaguered euro is being bolstered by passive monetary tightening at the European Central Bank, a current account returning to surplus and foreign demand for undervalued European assets. More recently we have argued that these dynamics will continue to prop up the euro in the early stages of 2014. Even if the euro pulls back from resistance at US$1.38/EUR, we would still expect the currency to hold firm in the US$1.34-1.38/EUR range in the near term.

Flirting With Resistance
Eurozone - US$/EUR

Core View:

Despite seizing on a tactical opportunity to go bullish the euro in 2013, we remain medium-term bearish. The 15-month stretch of stability in the financial markets has proven to be a remarkable vindication of the European Central Bank's 'soft' interventions ('whatever it takes' pledge, Outright Monetary Transactions commitment, etc.), but this masks the severe fractures that have undermined the integrity of the currency union. Suboptimal economic rebalancing (epitomised by demand collapse in the periphery rather than substantial gains in competitiveness), financial Balkanisation in the form of falling cross border asset holdings, and lasting damage to long-term potential growth from the financial crisis, will ultimately return to the fore and trigger renewed euro depreciation.

Passive Tightening Has Strengthened The Euro
Eurozone - US$/EUR & ECB Balance Sheet (EURbn)

Given the lack of structural reform and almost negligible inroads into establishing a combined banking, fiscal and political union, we continue to argue that the eurozone can limp on, but will remain a suboptimal currency area that will not work to the full benefit of its members. In the absence of structural reforms any growth rebound will top out below the rate needed to stabilise public debt burdens and drive down unemployment. As such, we continue to assert that the ECB has a pivotal role to play in providing enough monetary stimulus to grease the wheels and safeguard the integrity of the eurozone while policymakers tentatively embark on the next stage of European integration.

This is very much a medium to longer term dynamic that will weaken the euro. In 2014, a new threat is emerging: deflation. Although the ECB appears to be nonchalant regarding the risks of falling prices (referring to well anchored medium-term inflation expectations) we are not so sanguine. Headline inflation for the bloc has been lingering under 1.0% y-o-y since October, which is not only well below the ECBs 2.0% target, but is also the lowest level since 2009. We have two broad concerns: one is deflation itself; the other is deflation specific to the eurozone.

Although some policymakers (particularly in Germany) believe that falling prices are a necessary component of economic rebalancing, especially in the periphery, deflation is a toxic dynamic which goes against the grain of rising output and is far more difficult to control than inflation when it sets in. In an environment of falling prices, consumers and firms can choose to defer spending in the expectation that goods and services will be cheaper in the future. In the face of weaker demand, firms cut output and reduce prices further to bolster revenues, in what can become a vicious circle. Moreover, in a heavily leveraged economy, falling prices severely undermine debt sustainability, which given the eurozone's substantial public debt loads is a cause for concern. As the Japanese example of the last two decades has shown, a failure to act swiftly and resolutely can mean that deflation sets in and becomes more difficult to root out.

We are also concerned about the prospect of deflation specific to the eurozone. As we mentioned above, European financial markets may be experiencing calmer waters, but the eurozone is still hanging on by a thread (or, at most, several threads). This means that deflation could prove to be a far more destabilising dynamic than one would otherwise expect. In addition, with the credit transmission channel still broken and stark differences in risk premia persisting, the ECBs ability to engineer a single monetary policy for the eurozone has been severely impeded. Therefore if outright deflation does materialise, the ability of the ECB to combat it will be set back by both its own cumbersome policy response and an inability to target policy at individual states most at risk.

We believe that the issue of deflation will come to a head in 2014. Either prices stabilise from here and gradually pick up alongside the economic recovery, or the two-year spell of disinflation continues and transitions into deflation. Both cases demand further intervention from the ECB, with the latter requiring more urgent and aggressive action. These dynamics are in stark contrast to the US and UK where rate expectations are ramping up and suggest that the eurozone has fallen further behind in the economic and monetary policy cycle. This divergence ultimately plays out in our medium-term bearish US$/EUR forecasts.

In light of the euro's strong start to the year and the increasingly improbable arithmetic of reaching our previous US$1.27/EUR forecast for 2014, we have upped our target average to US$1.31/EUR and expect the euro to head towards the US$1.25-1.30/EUR area in the second half of the year. We note that having been almost bang on consensus for this year (US$1.28/EUR), we are now more bullish on a relative basis. We have also nudged up our 2015 projection to US$1.25/EUR from US$1.23/EUR.

Risks To Outlook

In light of persisting EUR strength, the risks to our forecast lie to the upside. Insufficient action from the ECB, further turmoil in emerging markets, or disappointing data out of the US, could keep the euro pinned at a high level against the dollar and on a trade weighted basis. However, we believe that this in itself would trigger monetary policy easing. There is only so long that the eurozone, and by extension the ECB, can tolerate a strong euro, low inflation and weak growth.

Holding Firm Against The Dollar And On A Trade-Weighted Basis
Eurozone - Trade-Weighted Euro Index

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