Oil Twin Win Bond
Since the start of the year we have been bullish on the dollar versus the euro and until recently that has been the wrong call. Euroland inflation is too low, and economic activity remains sluggish. But at least one thing is going the European Central Bank’s way. Its hankering for a weaker currency is now being fully gratified. The euro has fallen to well below the $1.30 level.
A fall in the single currency is just what the ECB wants. A weaker euro will lift inflation – the central bank’s current priority. Austrian central bank governor Ewald Nowotny has acknowledged recently that rates were cut again on September 4 partly to help weaken the euro, and that an exchange rate was “going in the right direction.” More of the same would clearly be welcome in Frankfurt.
Traders are likely to oblige. They know how painful it can be to flout the central bank’s wishes. Since the ECB initiated negative deposit rates – the floor for Euroland money market rates – in June, the average overnight bank-to-bank lending rate has also turned negative. This means some banks are paying to lend euro to others. They will soon pay even more for the privilege, given that the latest rate cut will further depress interbank rates. That is even before the ECB pumps more liquidity into the system.
All in all, we are expecting the greenback to appreciate further as the Federal Reserve stops printing dollars like monopoly money. Federal Reserve money-printing has debased the world’s reserve currency. Furthermore, the markets are soon likely to start pricing in 2015 rate hikes from the Fed. In contrast the ECB is unlikely to be raising rates until 2017 at the earliest.
All things considered, the euro still remains over-valued and needs to fall sharply if the ECB is to meet its inflation target, and boost the growth prospects of the Eurozone economy. A depreciation of the single currency would improve competitiveness and tend to raise inflation, which at just 0.3% remains too low for comfort. The obstacle is German exports that are in no need of any competitiveness boost. Germany’s roughly $250bn annual trade surplus rivals China’s. But a decline in the euro to $1.25 by year-end does seem possible as interest-rate differentials shift in the dollar’s favour.
Attempts by the European Central Bank to weaken the euro have the potential to spark a currency war but policymakers across the world are keeping silent, knowing the ECB has scant alternatives to keep its economy afloat. Eurozone central bankers have spelled out the need for a weaker euro to breathe life into the bloc’s economy, which flat-lined in the second quarter and is flirting with deflation. Such comments are usually a no-go among the big industrialised nations for fear that one country’s bid to become more competitive might trigger a race to devalue currencies and prompt other economies to resort to protectionism.
But ECB measures that have helped push down the euro to below $1.27 from just shy of $1.40 in May have drawn little objection. These include verbal interventions, cutting interest rates close to zero and a pledge to flood the banking system with money via cheap loans and purchases of private-sector debt. Japan got a similar pass from its G20 peers last year when Prime Minister Shinzo Abe launched an aggressive mix of monetary and fiscal stimulus that pushed the yen sharply lower. Having urged Tokyo for years to do something to galvanise its listless economy, other major economic powers could hardly complain about such “Abenomics”.
The problem for the ECB is that its new funding may not pass through to businesses and households as intended. Many Euroland banks are still laden with bad loans and struggling to meet regulatory demands for more capital buffers, while uncertainty from the conflict in Ukraine and a sanctions war with Russia could spoil companies’ appetite for new loans. A weaker euro might be a more effective remedy.
With the Eurozone doing worse economically than the United States and United Kingdom, a weaker euro against the dollar and pound is just what the doctor ordered. With the weaker currency, there should be an end to the litany of financial shocks originating in Europe that have perturbed US financial markets for the last four years. The United States has criticised currency policies in the past – urging China, for example, to move towards a market-determined exchange rate – but its bigger concern now is possible deflation in Europe. Some recent steps and further discussion in Europe toward a more accommodative pro-growth strategy are encouraging, but boosting domestic demand is key and efforts to do so should be supported by decisive actions across a full range of economic policies – fiscal, structural and monetary.
We see the euro weakening against most other major currencies on a 3-month to 6-month outlook, with every possibility it could drop to $1.20-1.25 range versus the dollar and 0.77 versus sterling.
Sterling should be trading somewhere between the high 60s and the low 70s based on its historical long-term average against the euro/deutschemark. The UK economy is recovering strongly and is set to be the fastest growing of the major G7 bloc in 2014 and 2015, with the increase in real GDP this year set to be three times as much as that of the Eurozone.
UK house prices too are rising sharply, with this trend set to continue over the coming months, adding to the view that the Bank of England will be forced to raise interest rates sooner rather than later. Indeed, it is still possible that it will be hiking rates before the year is out, and if not before the close of 2014, then in the first quarter of next year.
UK inflation in general is likely to be remain elevated, and is more likely to exceed the official 2.0% target level over the next 12-18 months, the opposite to the situation in Euroland, again supporting the need for a strong currency.
A quickly improving UK labour market should lead to higher wages this year, in turn putting more upward pressure on inflation. And with a General Election next year, politicians will be well aware that the public likes a strong currency so they can avail of cheap sun holidays abroad, another reason why the pound should strengthen over the next year or so.
All in all, we see the pound holding below the 80p level to the euro over the remainder of 2014, trading in the 75-78p range over the next few months.
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