EZ and US Politics Won’t Block EUR Rally to 1.30

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Euro was on a tear last week, rising to its highest level in 4 months against the U.S. dollar. A new bond purchase program from the European Central Bank and weaker non-farm payrolls report broke the EUR/USD out of its 2 week range. With the summer now behind us, the question ahead is whether the increase in volatility is here to stay and more importantly, whether EUR/USD will continue to rise higher. In the world of FX, we know that politics trumps economics and this week, there’s been talk that politics could influence the outcome of the 2 most important event risks this week, which could in turn affect the value of the EUR/USD. However in our opinion, political wrangling won’t stop the EUR/USD from reaching and possibly exceeding 1.30 because the economic consequences of blocking any additional support for the Eurozone or U.S. economies would be politically damaging.

German Constitutional Court Won’t Have the Guts To Block Rescue Fund

The first politically sensitive event risk for the euro will be Wednesday’s German Constitutional Court Ruling. Up for vote is the legality of Europe’s permanent rescue fund, the European Stability Mechanism (ESM). While the German government, European Central Bank and the rest of the world for that matter know that the ESM is a crucial element of Europe’s solution to their sovereign debt crisis, more than 35,000 people have filed a petition to Germany’s version of the U.S. Supreme Court to block the ESM for violating the EU Treaty’s no bailout clause.

While this is the country’s largest mass complaint ever, there is very little chance that the 8 scarlet-robed justices of Germany’s top court will risk sending Europe back into turmoil by standing in the way of the ECB’s new bond purchase program and Europe’s rescue fund, the region’s main source of stability. The political and economic consequences of blocking the fund are just too severe. If the justices vote to strike down the ESM, Europe would have another near death experience with bond yields would soaring, stocks collapsing and the EUR/USD falling quickly from the uncertainty. In response, the German government would probably call a referendum to change the German constitution and challenge the ruling of the court. We don’t think the Justices will want to open Pandora’s box especially since this is only the first of a two-step process. The court is only voting on an injunction to block the country’s ratification of the ESM. A final ruling on the Constitutionality of the ESM is set for December and all other nations outside of Germany, Italy and Estonia have ratified the rescue fund.

However in return for allowing the ESM to proceed, the courts could ask for more involvement of Parliament, which could make getting German support for new bailout deals more challenging. If the Court asks for additional conditions, the euro could sell off initially but rally eventually because the German government can still proceed with ratifying the ESM and the ECB can proceed with implementing its new bond purchase program. Yet any conditions will most likely come with the December constitutional ruling and not the ruling on the injunction this week.

Given the severity of the consequences economically and politically, we don’t think the German court has the guts to stand in the way of the rescue fund and if we are right, their decision would support further gains in the euro.

U.S. Elections Won’t Stand in the Way of More Fed Stimulus

The second major event risk for the EUR/USD this week is the Federal Reserve’s Monetary Policy announcement on Thursday. At one point, many people believed that the Fed would not engage in a third round of Quantitative Easing before the November elections to avoid any criticism of partisanism. However after last week’s disappointing non-farm payrolls report, few people can argue that the U.S. economy doesn’t need more help. The Federal Reserve is gearing up to ease and the only question is how far they will go. We expect the central bank to alter the rate guidance language of the FOMC statement and extend their low rates pledge from 2014 to 2015. There is also a greater than 75% chance that the central bank will announce QE3 outright or lay the foundation for a new round of asset purchases in October. How far they will go will depend on how aggressive they want to be but either way we don’t expect the central bank to stand by idly and do nothing this week just because of the U.S. elections. Political wrangling in the U.S. won’t stand in the way of further gains in the EUR/USD because the additional stimulus that the Federal Reserve will announce this week will be bearish for the greenback.

This is an extremely busy week in the financial markets. The German Constitutional Court plus Federal Reserve meeting are the most important event risks for the EUR/USD, but they are just the tip of the iceberg. The European Union is also expected to put out its proposals for a banking union, Standard & Poor’s should conclude its review of Spanish debt this week and Eurozone Finance Ministers will be meeting in preparation for the EU Leaders Summit in October. In other words, there’s a lot going on that can trigger big moves for the euro!

Kathy Lien
Managing Director

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