Will it be another year of humble pie for EUR bears?


Last weeks equity market sell-off and Emerging Market currency rout have still not damaged the Teflon coated EUR and it stands proud still in forex markets.

The vast majority of analysts are predicting a lower EUR/USD this year. In fact despite so many wrong calls last year, most are unrepentant. I would be firmly in that camp but am more convinced that at present levels the risk reward is heavily in favour of short positions. So what if anything makes this year different for the EUR and indeed for the EUR/USD.

We are of course not far away from where we opened up last year at EUR/USD 1.32. In 2103 a range of 1.2756 to 1.3832, just over 8%,was very small compared to other currency pairs.What’s more we ended the year higher, so why should we be convinced that this year will be any different. Current trends might well see a brief move over EUR/USD 1.40 but merely adds to the downside gains possible later on in our view.

These are the reasons the Euro will lose its shine and eventually test our EUR/USD sub 1.20 target.
  • Lagging the US in growth and way behind on any interest rate rising cycle
  • Deflation or at best very low inflation leaves debt trajectories in peripheral Euro zone countries headed towards crisis levels.
  • The ECB hijacked by Southern Mediterranean states including France,will adopt a much more aggressive expansionary policy and will react to any further strengthening of the EUR
  • Banking stress tests, which will surely be very tough as the ECB protects its reputation will expose the weakest banks ,requiring huge capital infusions at best.
  • Investment in Eurozone peripheral bonds, (where further gains are very doubtful) and last years equity market inflows will slow and eventually reverse.
  • France, the ‘ Elephant in the Eurozone Room’ as it lags its neighbours in reforms and a weak President who cannot face-off powerful unions.
  • Vulnerable to any global shock and its fragile recovery ( Draghi’s words) could reverse very quickly.
  • EU elections in May produce a huge anti EU anti EURO vote which cannot be ignored by politicians who seek to protect their domestic majorities.

Last Year

Mr. Draghi’s famous words,’ Whatever it takes’ were a watershed in underpinning the EUR. Confidence, be it temporary or not, has returned to peripheral bond markets attracting foreign investment as it chased higher yields. Investors were also underweight in European equities while other bombed out assets also attracted investment. So it was a steady rise upwards, all be it interspersed with the odd quick sell-off as some event triggered nerves. In truth there was very little panic and much of the volatility emanated more from JPY cross business. Euro economies were seen to be pulling out of recession, all be it growth in the Euro zone was at snail's pace and lagged the US.

What fundamentals are negative for the EUR ?

Growth.
Latest IMF predictions for 2014 growth in the Eurozone are 1%, consistent with many forecasts. As we know that compares poorly with the US and UK where growth of around 2.5% and quite possibly higher in the US, is expected. What adds to the problems in the Eurozone is of course the diverse numbers that make up that 1%. Germany as usual will be higher ( nearer 2%), Mediterranean countries including France will be lower nearer 0%.

Unemployment.
With Eurozone unemployment barely expected to dip from its 12% level and again the massive divergence, once again the Southern Mediterranean countries will struggle to see much inroads into their elevated levels. Youth unemployment remains at crisis levels in many countries within the Euro zone. Aside from the human tragedy, it sows the seeds for massive problems in years ahead and in the short-term weighs heavily on government budgets.

Fiscal policy
The Euro zone’s Fiscal Compact means many in the Euro zone have further spending cuts baked into this years budget. While the drag on growth from austerity will be much reduced in the US, it remains a huge constraint to growth within Europe. Very low inflation or deflation would cause debt to GDP levels to rise. This has already begun in some Eurozone countries. Debt trajectories remain a huge problem.

ECB policy
1. Despite denials the history of the ECB shows a huge bias to being proactive when raising rates (on even a whiff of inflation) while it has been far more reactive when cutting rates. That is still very much the case but could change this year. Many economists believe the ECB remains behind the curve.
2. Deflation concerns have arrived but generally remain low. The IMF estimated the risk at between 10 and 20%. However, while we may not get deflation we WILL get lower inflation. Austerity has been a major force in driving inflation lower meaning that deflation does indeed exist in some Peripheral countries. Austerity and a spend thrift public mean Euro zone inflation rate will fall even if it does not turn into full deflation this year.
3. Who’s running the ECB? There has been speculation for a while that the Northern European countries might find themselves hijacked by the Southern Mediterranean countries. The swing nation could be France who might grasp the moment to force through a far more expansionary policy. This was already evident in the vote to cut rates in November where Germany’s Bundesbank Weidmann found himself outvoted 17 to 6 as he opposed it. With the UK seemingly decoupling from the Eurozone’s sluggish growth and high unemployment, helped by BOE policy, it is not difficult to see a more forceful and successful lobby inside the ECB this year.
4. EUR exchange rate. Mr. Draghi has always alluded to the exchange rates influence on inflation levels while dismissing any exchange rate target. However, should we move much above EUR/USD 1.40 I am convinced a fairly quick reaction will follow. This once again will be led by the French and Southern Med countries.This is another reason to add to the ‘ risk reward’ of shorting the EUR.
5. Bank Stress Tests. Stress tests that the ECB will conduct in November. The ECB will be bound by its reputation to be tough. Many consider that some banks may fall well short of a ‘pass mark’. This is most likely in the periphery and will certainly interrupt and reverse the current relaxed attitude to the Euro zone periphery. If the ECB goes soft then the fall-out might be worse if a bank given a pass were to get in trouble. The ECB is already treading a narrow line by refusing any risk weighting to sovereign debt. Only this weekend Reuters reported that German newspaper Wirtschaft Woche had stated that an OECD report suggested European banks have a shortfall of € 84 billion and named specifically French and German banks.

France
France is the "Elephant" in the Euro zone room
. I have long believed France would be the defining country for the Euro. President Hollande’s speech last week seemed to indicate that at last he has woken up and smelt the coffee, wherever that was. He has committed through the ‘ Responsibility Pact ‘ to help industry with tax cuts in exchange for jobs'. Importantly he has promised huge cuts in government spending. What could possibly go wrong?

I believe it can go one of two ways.
1. If President Hollande can persuade the French public to swallow a decline in living standards, the internal devaluation, he will have pulled off a remarkable feat. However, he will be adding in a big part to deflationary pressures with the Euro zone .That is when I believe the Mediterranean block ( led by France) will complete its hijack of the ECB.’
2. If President Hollande does not get the political backing to follow through these policies or if the bloodletting in the streets produces a back pedal as it has already this year then it's worse news. France will continue to lose ground against Spain and Italy as they muscle in on French exports. Budget figures will continue get worse, unemployment will hardly move. Indeed France will not only fail to converge it will start to diverge again from Germany and this time the periphery as well. Once again I suspect the ECB would be hijacked as above.
It also remains to be seen if Mr. Hollande’s new supply side socialism would work if indeed enacted or quick enough if it were.

Politics.
While the politics within the Eurozone ebbs and flows, by and large its main stream parties have all backed the Euro and the EU as a whole. However, this May EU elections could signal the biggest ‘ bloody nose’ for the EU that has ever been. The Anti EU vote in many countries could be in the majority even if it never translates to domestic polls. It could render the EU parliament unable to legislate. Now we all know the wheels of commerce will carry on regardless, but EU politicians would be bound to take notice.

Timing
Of course timing is the essential ingredient for Forex trading and many will want to await their chosen ‘ Technical signal’ to short the EUR . Indeed as we edge up towards highs in EUR/USD little seems to have changed from last year. I am not sure what the catalyst will be for a new bearish run on the EUR and particularly EUR/USD. Indeed recent data continues to support the modest recovery in Euro zone economies. However, the fundamentals for a big fall in the EUR are increasing with each day and any Economic shock will surely tip the scales. In any event, Risk/Reward remains heavily to the downside.

What could turn things upside down.
Could Germany possibly have a change of heart and give its blessing to Eurobonds, fiscal transfers etc. Well unless you see an end to democracy I give that odds of less than 1%. My long shot (and it has been for a while) is that while all the talk was of a Grexit, the first country to leave the common currency will be Finland. That’s unlikely any time soon but no more off the wall than an attempt for greater integration at this point of time.
Geopolitics remains volatile in many areas not least sabre rattling between China and Japan. No one is quite sure, and one suspects that includes Chinese politicians, how their domestic liquidity or banking problems will pan out. So EUR/USD 1.20 might be a modest call and Gold at $3000 not so crazy.

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