Have the Euro’s Troubles Returned?

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U.S. markets are closed for Presidents Day today, which means that it will be a lighter in terms of volume in the FX markets. The G20’s decision to spare Japan from being singled out this weekend is the big story as most of the currency language in their communiqué was left unchanged. It is no surprise that the Yen is trading lower as only 2 new sentences on currencies appeared in the statement that said, “We will refrain from competitive devaluation. We will not target our exchange rates for competitive purposes.” It was a close one for Japan but now that the G20 meeting is over, the great Yen short can resume. The next catalyst for Yen weakness will be the nomination of Bank of Governor who will undoubtedly reaffirm his plans to ease monetary policy aggressively. However the euro could challenge the Yen for the limelight this week as investors look to economic data and the European Commission’s forecasts for clues on whether the 5% decline in stocks and sharp contraction in Q4 GDP growth means that euro’s problems have returned.

European Commission’s Growth and Deficit Forecasts Pose Risk to Euro

While investors were focused on what policymakers said about the euro last week, one of the most important comments came from the head of European Sovereign Ratings at S&P. Moritz Kraemer warned that Spain, France, Italy and Portugal are at risk of being downgraded this year. If this week’s economic reports and European Commission’s growth forecasts suggests that this risk has increased, then the euro could be in big trouble. The decline in Eurozone GDP growth in the fourth quarter raised concerns that the complete lack of growth last year and the prospect of a flat first quarter will make budget deficits in the region even more unsustainable. Germany has been carrying the Eurozone on her shoulders and this week we learn whether she continues to do so vis a vis the IFO and PMI reports. If economic activity in Germany continues to surprise to the upside, the euro could find support but if there are any downside surprises, the currency could tumble quickly. However based on other economic indicators such as factory orders and industrial production, Germany has had a steady start to the year. The Bundesbank also said that the German economy will return to growth in the first quarter.

Yet the European Commission’s growth, unemployment and deficit forecasts will be more important. While its possible that the EC will look beyond the contraction last year and focus on the signs of growth in the coming year, there could still be concerns about deficits and the currency. Aside from the potential changes to their growth estimates, we will also be looking to see if budget deficit forecasts are increased. If Spain’s budget deficit is expected to exceed 8%, it could also raise the risk of a downgrade for the Eurozone’s fourth largest economy. If the forecasts remain largely unchanged however, it could help the euro.

ECB President Draghi will also be speaking before the European Parliament this week but we don’t expect him to change his view that the euro is near its long-term average.

Italian Election Uncertainty

Meanwhile elections in Italy could also pose a big problem for the euro over the next 2 weeks. The elections are being held on February 24th and 25th and between Monti calling Berlusconi a buffoon and Berlusconi slurring in a speech, this will be an interesting one. The leader of Italy’s center left party, Pier Luigi Bersani is neck to neck with former Prime Minister Berlusconi. No one is expected to win a majority and right now, it appears that Bersani is leading slightly in the polls and if he wins he will most likely form a coalition government with Mario Monti’s centrists. This is probably the best case scenario since it would offer assurance of continued reform in Italy. However the elections are close and can still go any way and the worst case for investors and the euro would be a win by Berlusconi because he plans to abolish unpopular property taxes that were the cornerstone of Monti’s austerity measures. A return to the free spending days of Berlusconi would be a big hit to confidence and would increase the risks of a downgrade for Italy and along these lines, the uncertainty surrounding the Italian elections also poses a risk for the euro.

FOMC Minutes – More Talk of Phasing Out Asset Purchases

Finally the Federal Reserve will be releasing the minutes from its last monetary policy meeting in January. If you recall, when the Fed released the minutes from its December meeting, the talk of phasing out asset purchases sent the dollar soaring. The January FOMC statement made no mention of ending asset purchases this year and that was not surprising considering that only policy changes and not discussions make it to the final statement. However talk of phasing out asset purchases could resurface this week and if the central bank sounds serious about starting to unwind some of its emergency stimulus, the dollar could trade higher, putting downward pressure on the euro. Yet investors may not pay much attention to these discussions because they realize that at the end of the day, this is a view shared by a minority of FOMC members and even if the idea gained traction, the Fed is still very far away from taking it seriously.

Kathy Lien
Managing Director

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