The markets’ faith that an economic recovery is taking hold, the Eurozone crisis is behind us and central banks will continue to be a benign liquidity force has been shaken this week. Volatility has risen, stock markets have fallen and the dollar is poised to get its groove back. However, as we end the week expectations that the Fed will abruptly end QE3 are being scaled back and the focus is shifting back to Europe’s growing list of woes.

The near-term issue that could weigh on the euro is the Italian election on Sunday and Monday. Essentially there are two bad outcomes: 1, no clear winner, which causes political instability to continue and 2, a win for Berlusconi. Read our Italian election preview that will include our thoughts on potential market impacts for more on this. Political instability in Europe’s third largest economy, which is laden with debt and plagued by weak growth and high levels of unemployment, is euro negative, in our view.

Weak growth to plague Eurozone for some time yet

The longer term issue is the stagnant growth and high levels of unemployment in the currency bloc. The European Commission’s winter forecasts were released this morning. The news was bleak. Growth won’t return to the currency bloc until 2014, the EU now forecasts growth to contract this year by 0.3%, down from the 0.1% growth it predicted back in November. The highlights from the report are in the table below. There were reports yesterday that up to a third of Italian companies could go under due to the weak economy in the Eurozone. How can this not halt gains in European stock markets? It appears that Eurozone officials are good at pointing out the problem, but bad at dealing with it. They know growth is unacceptably weak and unemployment is unacceptably high, yet there has been no euro-wide action to break this destructive contraction cycle and the official line is still fiscal consolidation at all costs.

Growth could force ECB to accommodative action

The EU forecasts make it likely that the ECB Staff forecasts, released at the next ECB meeting in March, will also substantially revise down growth prospects for the currency bloc. Thus, the ECB’s dream that the Eurozone economy would recover in the second half of this year is unlikely to come true any time soon. As economists parse the data the key point for traders to note is that this data supports a dovish ECB. Potential rate cuts are on the cards sometime over the next few months, to try and improve the “transmission mechanism” of monetary policy to the real economy. This is currency negative and could thwart any euro rallies.

We believe that Draghi called the top in the euro earlier this month when EURUSD was above 1.37. We are less than 200 pips away from the key 1.30 level. The trigger for a sharp decline below here towards 1.20 could be a couple of things: 1, political crisis in Italy triggering a sharp rise in bond yields or 2, the ECB’s balance sheet starts growing again. In fairness these two things could be one and the same – i.e., the ECB’s balance sheet could start growing again because of a spike in bond yields. The bigger effect on the euro would be if the ECB starts to expand its balance sheet at just the same time as the Fed looks at slowing down the pace of expansion of its balance sheet. Expansionary policy by the ECB versus contraction or stable policy by the Fed could see a sharp reversal in EURUSD in the coming months.

Get ready for a reversal in ECB balance sheet contraction

The ECB’s balance sheet has contracted by nearly 10% in recent months, this essentially means that the ECB has been taking money out of the economy, rather pushing it into the economy, when that happens it should be currency positive as it is limiting the supply of the currency. Part of this contraction was down to the early repayment of LTRO 1 – when nearly EUR 140 billion was paid back to the ECB 2 years early. However, that now looks more like a token gesture. We found out this morning that early repayment of LTRO 2 was much lower than LTRO 1 at EUR 61 billion, missing analyst estimates of EUR120 billion. This caused a sharp drop in EURUSD. A weekly close below 1.3185 is a very bearish development for this cross and would open the way for a steeper decline back to 1.3060 and then 1.30 in the near term.

FX and stock markets reacting in different ways to Euro news

Interestingly, the FX market and stock market is reacting in opposite ways to the European data. Stocks are higher across the board along with the Eurostoxx index, which is up nearly 1.5% so far today even though EURUSD is lower. Stocks seems to be moving on the back of two things: 1, the better than expected German IFO data, which suggests that the largest economy in the currency bloc is firing on all cylinders, and 2, the slowdown in LTRO repayment means there is more liquidity in the system, which is traditionally positive for equities. Stocks could also be unwinding some of the shorts from earlier this week as the market scales back its concern of an early and abrupt end to QE from the Fed.

Overall, we believe that the euro is set to move lower in the near and medium-term. Italian election risks and a terrible growth outlook are likely to force the ECB into dovish action in the coming weeks, which will weigh on the single currency.

EURUSD

EU forecasts – growth, unemployment and Debt as a % of GDP

EU Forecasts