EUR: Monetary Expansion Means Falling EUR

EUR: Monetary Expansion Means Falling EUR

Despite a EUR rebound in the latter half of January, we have revised our EURUSD forecasts lower. European growth remains weak and the debt crisis is still unresolved. Austerity measures will further weaken growth, but for certain countries, they are necessary to maintain market confidence. Our economists expect 50bp in rates cuts by the end of this quarter, and QE in the spring/summer. Poor growth and loosening monetary conditions will weigh on EUR, and we see it becoming a funding currency .

That said, there is possibility for some short-term strength over the next few weeks, but we believe that any rebounds in EURUSD will be temporary. Two key risk events in February will be the ECB’s second three-year LTRO and the March Euro Council meeting. Optimism surrounding both of these events could lead to EUR rallies, but we are skeptical of any gains.

A larger-than-expected LTRO take-up could support EURUSD, but it would not provide a long-term solution to the European problems, so this would fade eventually. Regarding the EU council meeting, while there is certainly room for upside surprises such as a leveraged ESM, the main items on the agenda will likely be the size of the ESM and the fiscal compact. Even if the size of the ESM is increased, this is not ultimately a game-changer, in our view. As long as the European rescue mechanism is limited in size, there will be no fiscal backstop, and risks will remain.

Regarding the fiscal compact, if it is watered down, this is EUR-negative as it illustrates a lack of political commitment to solving eurozone problems. However, if the version that passes satisfies the ECB, this makes it politically easier for it to enact expansionary monetary policies which will weigh on EUR. There is very little room for a long-term positive outcome for EURUSD on this front.

Though we have seen some signs of stabilization out of Germany and in various business cycle indicators, European data on the whole remain weak, with retail sales, unemployment and industrial production still soft. Additionally, stabilization remains vulnerable to a tightening in financial conditions, which could be brought about if there is renewed concern surrounding the sovereign debt situation. As a result, further central bank easing to protect against risks to the economy remains likely, supporting our call for EUR to be used for funding purposes.