Euro might stabilize by the end of Q2 2015

Christian Henning Schulz, Senior Economist at Berenberg Bank, on Euro zone

Europe’s largest economic engine Germany has returned back on the growth track. The business confidence increased for a fifth consecutive month in March. Another survey data is expecting that Germany should face GDP growth by the end of this quarter. However, it is still debatable whether a stronger German economy will help the Eurozone overall. How do you evaluate the current situation?

Germany and Euro zone as a whole are experiencing quite strong economic tailwind at the moment. First of all, cheaper oil helps consumers in particular, as we have seen German retail sales almost rocked-up throughout the year 2014. Moreover, we expect that consumers will have a pleasant year with inflation rate being very low and wages rising moderately, which obviously boosts the real purchasing power. Another factor that should be mentioned is the cheap Euro.

As a matter of fact, a weaker Euro versus the Dollar helps exporters on the markets. Finally, the European Central Bank recently launched QE program, which buys sovereign bonds and other assets, driving down the cost of borrowing, thus, helping to bring new investments. There is quite a list of those tailwinds from which countries like Germany or Spain benefit strongly on the fundamental levels. Taking into account, whether Germany’s economic rebound would help the rest of the Euro zone, depends largely on whether the Euro zone can favor the increased demand of German exports. In my opinion, this benefit could take place.

The reason being is that many Euro zone countries have already improved their competitiveness and are now producing goods that consumers actually want for the prices they can pay. At the same time, non-Euro zone producers will suffer from the depreciation of the Euro at least for now. For example, Northern countries alongside with Spain and France have a competitive advantage over other countries exporting to Germany, and should benefit from its demand. However, rest of the Euro zone becomes less dependent on German strength than it did at the debt crisis, since the recovery of countries like Portugal is much more driven by domestic demand currently. While Germany is a nice add-on, it is still not the core, as it was three or four years ago.

The ECB president stated: “A sustained recovery is taking hold. We can rightly be optimistic about the outlook”. However, Greece still remains the largest threat for the Euro zone recovery. Officials have been trying to keep it in the Euro area for about six years now, and it looks like they are already running out of patience. While analysts expect Greece to stay with the Euro, others say it might be just a matter of time. What potential scenarios do you foresee?

We expect Greece to stay in Euro zone, whereas, we have three scenarios on this matter. The first one is that Mr. Tsipras and the current government will simply implement what it needs to, in order to obtain further money short- and long-term.

Greece is in need of more Euro zone assistance starting from July. Moreover, the country's negotiating position is weak and the economy is „falling off a cliff” at the moment, as there is a serious financial trouble for both the government and banks. Therefore, Greece has no other option than to accept the conditions which come with the help provided.

Hence, the scenario of Tsipras turning into a reformer is the one we see with 50% probability. There is, of course, another option, since the current Greek government is falling apart at the moment. It could be replaced by another government focused on greater reforms, particularly pro-European ones. That is expected to happen at 25% of chance, respectively, leaving another quarter for the so-called “Grexit”. In case this outcome would take place, accidentally or not, it will lead to a catastrophe in Greece and its citizens, whereas, for the rest of the Euro zone it is manageable, although it could mean some inconvenience as well.

What further impact do you expect from the QE program on the EUR/USD exchange rate and what are the possible consequences for the US interest rate hike?

The QE was announced in January, and now we are acquainted with the fact that the ECB is serious about implementing it. Taking things into account, there are no other surprises left, and hence, every outcome of QE is already priced in. In that sense, we do not expect the Euro to depreciate any further. Moreover, we do not see the interest rates to go down any further. On the contrary, from the QE program experience of the Fed or the Bank of England, on practice it actually leads to appreciation of the currency and a slight rise in the interest rates.

The reason being is that, as economic expectations improve, inflation anticipations rise and, therefore, long-term rate expectations go up. In fact, we foresee the Euro to strengthen against its counterparts. Additionally, the interest rates within the Euro zone are probably going to rise gradually. However, QE does bring is insurance against the downside risks, and every time the economic data disappoints, the ECB could always go even further, which is like an insurance policy for the rest of the Euro zone.

Where do you see EUR/USD and EUR/GBP in Q2?

If we believe in a story that the Euro should stabilize and strengthen versus the Dollar and other currencies, like the Sterling over the medium term, then, of course, we expect a roughly stable Euro exchange rate by the end of the Q2 of this year. For the time being, our forecast for the EUR/USD is 1.04 and 0.70 versus the Pound.