Reading the data
One of the main challenges that the European Monetary Union faces is that the area is far too diverse for the ECB to be able to run optimal monetary conditions. Conditions which might be too loose for the core economies might be too tight for those at the core. This dynamic often leads to policy errors and volatility.
With the current state of the EMU, it is not necessarily correct to simply read better data from core economies as EUR positive. For EUR to rally meaningfully would require stronger data out of the periphery, which has not been the case recently while we have seen a surge in the core German economy. What is also happening currently, of concern, is a widening of EMU spreads. The EMU’s TARGET2 balance sheet is now approaching levels not seen since 2012, just ahead of ECB chief Draghi announcing that the ECB would do “whatever it takes” to preserve EUR.
US & EUR
Germany typically benefits from lower EUR valuation which has recently contributed to an 8.6% GDP surplus for the country, a matter which has attracted comments from President Trump. Germany’s exports are now just shy of 50% of GDP, which represents one of the largest trading rations within developed market economies.
A stronger EUR would weaken Germany’s account surplus. However, the EMU is no longer focused on the performance of individual economies but rather on keeping the EMU intact. For this reason, it needs its weaker economies to move into focus regarding currency valuations. For the weaker economies, EUR may be too expensive, as indicated by a recent widening of sovereign bond spreads.
In light of this, the US administration’s comments are unlikely to have much of an impact on EUR beyond short-term position adjustments. Indeed, unlike the Obama administration, the new administration may see little value in the EMU which could be deemed as adding uncertainty to the equation, leaving bond spreads vulnerable.
Trading EUR on an anti-cyclical basis
Pro-cyclical currencies are far easier to anise as they tend to trade in line with data release, strengthening on positive data and weakening with negative data. However, anti-cyclical currencies tend to strengthen in response to weak data and weaken in response to strong data. EUR tends to trade in this manner.
As long as German economic strengthen is unaccompanied by better economic performance in the periphery, then EUR is likely to continue to trade on an anti-cyclical basis. This dynamic will either lead to the ECB allowing EMU yields to reach low enough levels to accommodate peripheral economies or, to EMU yield spreads dragging EUR lower.
EUR & Reflation
Typically, reflation is credit positive and therefore it does not surprise this time around that FX investors appear to be ignoring initial signs of EMU bond spread widening. With the Eurozone’s “one rate for all” monetary policy approach, necessary real effective exchange rate adjustments are entirely a function of widening inflation differentials as opposed to nominal exchange rates moving. This what we are currently seeing with German inflation surging higher while inflation rates in the periphery remain subdued. These widening inflation differentials should, over time, help shrink the gap in competitiveness between the core and peripheral economies, though this could be a drawn-out process.
EUR suffers from divergences
Nominal yields have risen globally because of reflation, and so long as this increase is supported by rising inflation and higher return expectations, then this shouldn’t be an issue. However, what we see currently in the Eurozone indicates growing stress which will lead to either a sharp decline in EUR or a widening of EMU spreads. Indeed, reflation could make it even trickier for the ECB to stabilize markets outside of OMT operations.
Populism vs. markets
If the ECB chooses to tighten monetary policy without first seeing data improvement in the periphery, then EMU will widen, and the effects of any ECB rate-hike and EUR rally would be fairly limited. A situation where boosting periphery funding costs undermines economic activity has the potential to further fuel populism in the Eurozone. In some periphery countries, populist parties have already developed significant support where the next round of government elections could see populist parties taking power. The ECB might feasibly need to consider this and maintain the current accommodative monetary policy. However, if it doesn’t, then EUR-denominated assets could weaken, potentially leading to a lower EUR.
It is often argued that populism doesn’t affect core countries. However, it is entirely possible that German populists could see a surge in support if the ECB doesn’t cater policy to suit German interests. If the policy is too tight and pushes periphery economies into difficulty, then this could require further rescue programs. The result would be a widening of deficits and weakened economic activity which could exacerbate political instability in the EMU. However, if the policy is too loose, this could further extend the economic surge in core economies and increase Chancellor Merkel’s chance of winning in September.
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