Euro Rejects 1.05, Can a Weak Currency Save Europe?

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Euro Rejects 1.05, Can a Weak Currency Save the Economy?

Daily FX Market Roundup 12.22.16

One of the best performing currencies today was the euro, which rose within a pip of 1.05 versus the U.S. dollar. While the currency pair soundly rejected this key level, its outperformance reflects the benefits brought on by a weaker currency. After losing close to 1000 pips over the past 2 months, the lower euro has dramatically changed the outlook for inflation and growth. In the latest economic bulletin released by the ECB, the central bank sees inflation picking up strongly at the turn of the year and this prompted ECB member Weidmann to say that the central bank should not leave a rate hike until its “too late.” More specifically, his concern is that “in case of unsound fiscal policy, monetary policy could come under pressure to forgo an interest rate increase even though a tightening would be warranted.” Many central banks including the Bank of England have expressed concern about higher inflation in the coming year and this view puts tapering into play. Part of the strength can be attributed to the central bank’s break in bond buying. In anticipation of lower market liquidity, the ECB announced last month that they would pause bond purchases between December 22nd and January 1st, resuming bond purchases on January 4th. Without the government’s hand in the markets, we could see a further rise in Eurozone bond yields and rebound in the euro.

The big question for Europe is whether a weak euro can save the Eurozone economy.
We have no doubt that the lower currency will boost economic activity and inflation – the data already shows the positive impact. However Europe’s problems extend beyond day to day business activity. The greatest risk for the Eurozone and the euro next year are politics, terrorism and a banking crisis in Italy. Some of these incidents are difficult to predict and each of these scenarios could have a dramatic impact on the currency and overshadow any positive improvements in the economy. Looking ahead to the coming year, we hope to sell rallies in the EUR/USD between 1.05 and 1.06.

It was another day of uneven trading for the U.S. dollar. The greenback traded higher versus sterling, the Australian and Canadian dollars but moved lower versus the euro. It was virtually unchanged against the Japanese Yen, Swiss Franc and New Zealand dollar. U.S. yields moved higher but mixed data kept the currency from experiencing big moves. Third quarter GDP growth was revised up to 3.5% from 3.2%, durable goods orders ex transportation rose more than expected but jobless claims jumped while personal income and personal spending growth slowed. Although the Federal Reserve sees 3 rate hikes next year, recent data has been far from impressive. In yesterday’s note we warned about the consequences of a stronger U.S. dollar and we should see more negative effects in January data. New home sales are scheduled for release on Friday but the impact on the dollar should be limited.

USD/CAD traded sharply higher today, breaking above 1.35 despite exceptionally strong retail sales and higher oil prices.
Consumer spending tripled expectations in the month of October, rising by 1.1% versus a forecast of 0.3%. September data was also revised higher. Excluding auto and gas, demand was even stronger with spending rising 1.4% against a 0.7% forecast. Consumer price growth slowed more than expected which is consistent with the IVEY PMI report but part of the change can be attributed to a new measure of core CPI. With U.S. rates rising more than Canadian rates today, USD/CAD took a crack at 1.35. Canadian GDP numbers are scheduled for release tomorrow and based on the sharp rise in retail sales, the risk is to the upside for the report. The Australian dollar also traded lower but thanks to last night’s healthier GDP report, the New Zealand dollar held steady versus the greenback. This helped AUD/NZD reject 1.05 for the fifth day in a row.

Sterling continued to trade lower against the U.S. dollar, driving EUR/GBP up to 85 cents.
It was another light day in terms of data. As we mentioned yesterday, the currency’s weakness can be attributed to ongoing concerns about Brexit. Next year is going to be all about how the U.K. economy weathers Brexit. Prime Minister May promised to invoke Article 50 in March so we are only a few months away from what could be another period of major uncertainty and volatility for the currency. On a separate note, the UK treasury has put into question the effectiveness and impact of the current monetary policy. In an open inquiry to the public the UK Treasury Committee states “Interest rates are stuck near zero, the Bank of England has used increasingly unconventional forms of quantitative easing, and inflation has been below the two per cent target for three years. The efficacy of monetary policy or otherwise, its unintended consequences, and its prospects, need careful examination.” With nothing left on the calendar for the remainder of the week, the pound should continue to underperform other major currencies.

Kathy Lien
Managing Director

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