Tuesday, February 12, 2013

Commentary: EUR is Over-Bought in the Short Term

The two major events of the FX market for the past several months have been the surging Euro and the imploding yen.  Both events have had distinct drivers, namely, the easing of the European sovereign debt crisis on the Continent, and the new LDP government's plans to enact a program which finally ends deflation in Japan.  It my judgment, the first of these trends will reverse somewhat, with the Euro ending the year in a 1.25-1.27 range against the greenback.  The yen on the other hand will continue its slide.  I expect USD/JPY to end the year at 105.  

Europe: The End of the Beginning

The summertime headlines foretelling the inevitability of Greece leaving the Eurozone have all but disappeared from the financial press.  Certainly, the tail risk of a catostrophic break up of the Eurozone drives gloomy sentiment, and the dissipation of this risk is supportive of the Euro.  However, real progress has been made in Europe since the summer on one very important front -- sovereign debt markets are functioning again.  Gone are the seven percent yields for Italian bonds which made it virtually impossible for Italy to balance its books due to the skyrocketing cost of its debt service.  Yields on Spanish, Portuguese, and Greek debt are down too, due to the implementation of credible austerity plans and support from the IMF, EU, and ECB.  The bottom line is that with the chaos on sovereign debt markets abating, the European economy has the potential to grow again.  That's not to say its growing now, indeed it is forecast to shrink by 0.4 percent this year.  However, Europe has escaped fate of being trapped in eternal economic limbo.  Now Europe needs to show that it can post solid economic performance again.  

Thus for Euro itself, the outlook remains negative, at least in short term.  With its economy still shrinking, European investment outlets remain much less attractive than their counterparts in the Americas and Asia.  Furthermore, the fiscal consolidation which has brought about a stabilization in the Eurozone sovereign debt markets will continue to work its way through the economy and will remain a significant headwind to growth for some time. The vicious cycle of ever rising debt service in the periphery countries has ended.  However, the cost, fiscal tightening at the expense of growth, means that it will years before these countries can safely use the capital markets to finance fiscal stimulus to promote growth, lest they risk all the progress thus far made.  

Therefore, though the catastrophe has been averted, much pain and further work still lies ahead.  In the words of PM Churchill, a champion of European integration who called for a "United States of Europe," "It's not end, it's not th beginning of the end.  But it is the end of the beginning." 

In sum, the recent rally in the Euro, caused by a dissipation of catastrophic tail risk, will fade as the relief of many investors have over the probably survival of the Eurozone runs into the reality of weak fundamentals, and strong macro-economic headwinds such as fiscal drag at all levels of government, and monetary policy which is already about as accommodative as it can get.  Overnight rates for Euros are already about 13 bps lower than for USD.  The ECB, unlike the Federal Reserve, does not target overnight rates as the main instrument of monetary policy.  Instead, it influences the money market by adjusting the rate at which it lends to Eurozone banks via its weekly repo transactions.  The result is that its distinct policy rate, currently at 0.75 percent, has resulted in even cheaper money market rates than in the US.  Therefore, the key policy rate for Europe is already close to its lower bound. 

To be sure, Europe is still a rich and vibrant society which enjoys countless structural advantages over most other economies, namely its political stability and educated populace.  Europe will comeback, but in the next year, in light of many challenges it still faces, EUR is going to dip to 1.27 per greenback in the coming year.           

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