EUR 2016 Outlook – Forget About Parity

By Kathy Lien, Managing Director of BKAsset Management

Six years after the financial crisis and the European Central Bank is still struggling to turn around their economy. As recently as December, they increased stimulus in a desperate attempt to revive growth and drive inflation higher. This illustrates how deeply entrenched the slowdown is and how poor of a job Eurozone policymakers have done this past year. In the third quarter, the Eurozone economy expanded by a mere 0.3%. During this same period the U.S. economy grew 2%. Inflation is low around the world but the approximately 10% slide in EUR/USD combined with the full scale QE program launched in early 2015 should have been more effective in boosting inflation, which ran at a 0.2% annualized pace in November – well short of the central bank’s 2% target.

2016 brings more challenges for the Eurozone economy. While the ECB is comfortable with the current level of monetary policy they will need to extend bond purchases beyond September 2016. September is only a soft target and we can’t see a scenario where growth or inflation will improve enough 9 months forward to warrant a reduction in stimulus. Also, if inflation and growth do not make significant upside progress, the ECB may need to expand the program in the coming year. The ECB’s decision to provide additional stimulus in December reflected their sense of urgency and their overall concern about the economy. Their efforts are paying off as there have been signs of recovery in the Germany but meaningful risks lie ahead. The prospect of further weakness in emerging markets, particularly China, unstable geopolitical situations in the Middle East and Russia, high unemployment, stagnant wages are just some of the problems posing downside risks for the Eurozone in 2016. Countries in the region will benefit from the new round of stimulus, weaker euro and low oil prices but the benefits will be slow to come. France and Italy have not made much progress in terms of growth and while Spain is doing well it is only the fourth largest economy in the region. The fiscal position of most Eurozone nations is also very weak with only a handful producing a budget surplus in the past 3 years. The largest sector, financials will suffer from negative deposit rates. Debt levels are high and major progress towards reducing that burden is not expected over the next 12 months.

The greatest risks for the Eurozone in 2016 are political. Greece will be back in the headlines as the government struggles to enact reforms and meet the demands of its bailout. According to S&P, the country is still at risk of default. At the same time, migration will be a touchy subject for Europe. In 2015, European nations welcomed millions of Syrian refugees with open arms but the Paris attacks have transformed the attitude within Europe and there are now calls for tighter border controls. These demands will quickly intensify if ISIS stages another attack in the region. There’s no question that there will be attempts and it will be up to European intelligence to avoid another catastrophe. In 2015 Russia’s brazen intervention in Ukraine shattered Europe’s illusion that conflict on the continent was long gone history. The EU was forced to enact sanctions, straining relations with Russia and in the middle of the year, they will need to decide whether the sanctions which last until July, should be scrapped or extended. So between sluggish growth, deepening refugee crisis, ISIS aggression and Russian tensions, 2016 will be full of challenges for Europe.

As for the currency, forget about parity. In 2015, many analysts saw parity in sight but euro never reached that level. In 2016 big names such as Goldman Sachs, Deutsche Bank and BNP Paribas still see that target being met. While the prospect of even higher rates in the U.S. and continued ECB stimulus will keep the euro under pressure, parity is nothing more than a headline grabbing target. Experienced traders know that these overstretched goals are hard to reach. We agree that EUR/USD will move lower in the coming year and see 1.05 being tested but weaker currencies drive stronger economies and at 1.05, the Eurozone stands to benefit significantly from the combination of ECB stimulus and a lower euro. When the benefits start to be felt through more consistent improvements in Eurozone data, the ECB will feel more optimistic about the economy and less pressured to increase stimulus and that could mark the turning point for the euro. For now, lets focus on the next 4 to 5 cent opportunity in currency. We expect EUR/USD to test its 12 year low of 1.0459 and then bounce 1 to 2 cents before figuring out where it wants to head next.

Technically, there’s only 2 important support levels in EUR/USD – the 12 year low of 1.0459 and parity. If the recent low is broken, it should kick off a quick slide to 1.0000. Taking a look at the longer term chart of the currency, a major top formation can be clearly seen. When EUR/USD broke its 2010 low of 1.1877, there was a quick drop to the 61.8% Fibonacci retracement of the 2000 to 2008 rally. This Fib level at 1.1215 is now resistance and a strong close above this level is needed to reverse the negative sentiment in the currency.

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