Now The ECB Must Prevent A Euro Uptrend

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Includes: FXE
by: RadaEcoWatch

Summary

Now that Brexit has become reality, the uncertainties for the eurozone economy abound.

The ECB focus over the next few months will be on the euro exchange rate as an appreciation of the euro would have a negative impact on economic outlook.

The main problem for the ECB is that the euro is significantly undervalued against major international currencies at current values according to the OECD estimate of purchasing power parity.

The ECB could extend the QE program – set to expire in March 2017 – as soon as in September and further ease monetary policy if the economic outlook deteriorates.

Now that Brexit has become reality, the uncertainties for the eurozone economy abound. A collapse in exports to UK could have a negative impact on the eurozone economy even if it is not likely to cause a recession by itself. UK accounts for only about 7% of total exports of the eurozone countries.

The political outlook is in our view the main source of concern as other countries could start considering leaving the EU. This could depress business and consumer confidence, lowering investments and consumptions.

In this scenario, we think the ECB focus over the next few months will be on the euro exchange rate, even if it will never admit that the euro is a monetary policy objective.

Indeed, an appreciation of the euro would have a negative impact on the outlook of economic growth and inflation in the coming months. According to an OECD forecast model, an increase of 10% of the single European currency against the main currencies would reduce the GDP growth by 0.8% after one year and by a further 0.9% in the second year. Inflation would be 0.7% lower after 1 year and 0.9% lower in the second year.

On Friday, the forex reaction to Brexit was mixed: the Euro declined against the US dollar, the Australian dollar and one New Zealand dollar but strengthened against the British Pound, the Swedish and Norwegian Krone.

The main problem for the ECB is that the euro is significantly undervalued against major international currencies at current values according to the OECD estimate of purchasing power parity. This could increase upward pressure on the euro.

The undervaluation range is from a low of 9.4% against the Canadian dollar to a high of 35% against the Swiss franc.

EUR/USD should be at 1.31 according to OECD's.

The eurozone trade balance surplus of 4.5% of GDP is a clear indication of the undervaluation of the euro exchange rate.

In this scenario, in the coming months the ECB should continue taking decision to maintain the two main elements in favor of a weak euro: the high interest rate spread between 2 year German and US government bond yields and the strongest expansion of its balance sheet compared to the Fed one. Both these elements had a very high correlation with the trend in the Eur/USD over the past years.

For this reason we see the ECB extending the QE program - set to expire in March 2017 - as soon as in September. The ECB could also decide to further ease monetary policy if the economic outlook deteriorates.

Latest economic data released in the euro strengthened our view that economic growth could slow in the coming months in some key countries, such as France and Italy. For example, in France the preliminary PMI composite index for June fell below 50. It signaled a possible recession in the coming months. In Italy, the PMI manufacturing index fell in May to the lowest level since February.

Moreover, monetary aggregates data for April indicated that the impact of the last quantitative easing on economic growth could be lower than expected. M1 growth rate fell from 10.1% y/y to 9.7% y/y, and M3 growth rate from 5% y/y to 4.6% y/y. Loans to the private sector increased by a modest 1.2% y/y

The Fed could help the ECB in maintaining the euro weak against the US dollar deciding to raise interest rates in July or confirming a tightening stance for the coming months. However, the chances that this could happen are now very low. Indeed, the Fed Funds futures are now discounting the possibilities of a rate cut in the coming months. No help should arrive from all other central banks, which in turn are engaged in devaluing their currencies.

Anyway, the negative impact of a possible appreciation of an undervalued euro exchange rate clearly indicates that the eurozone recovery is very fragile and that only a more pro-growth fiscal policy could spur economic expansion.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.