The Eurozone paradox remains intact as there is still scope for the currency to strengthen on bad news due to capital repatriation, a wide current account surplus and a reduction in carry trades. The ECB is also at risk of losing the global currency war. Overall, there is an increased longer-term risk that the Eurozone mimics the Japanese crisis in having permanently weak growth, a zombie banking sector and an over-valued currency.
There is of course a crucial difference in that Japan is a sovereign country while the Eurozone is a collection of individual countries. In this context, without aggressive integration, there is a high risk that prolonged political and economic stresses would trigger a collapse of the Eurozone area. Euro strength could therefore suddenly reverse very sharply with heavy losses.
The euro has been gradually appreciating over the past few months with notable gains on key crosses such as sterling with a recovery in EUR/GBP to above 0.7800 from lows below 0.7000. The euro sits comfortably above 1.10 against the dollar and the trade-weighted index has now moved to the highest levels since early 2015, stronger than it was before the quantitative easing program was introduced.
There have been worrying Eurozone developments on many fronts during the first few weeks of 2016. To an important extent these were out of Draghi's hands, but his own sense of invulnerability has certainly also slipped after the botched monetary easing at December's meeting.
There has been a renewed widening of peripheral yield spreads over German bunds as financial risk are perceived to have increased once again, especially in Italy. Overall growth in the euro area is likely to stumble again with very weak industrial production data released this week. In this context, the Eurozone is increasingly threatening to match Japan's dismal record of permanently sub-par growth in tandem with an overvalued currency.
The political atmosphere has become more toxic once again with deadlock in Spain as no government has been formed after December's general election while the new left-wing government in Portugal is on a collision course with the European Commission over budget policy.
German Chancellor Merkel is in a much weaker position ahead of state elections in March, depriving the euro area of leadership, while the provisional agreement on revised UK membership terms could collapse quickly.
The number of migrant inflows has slowed slightly during the winter, but number are likely to increase again and there has been no underlying resolution of the crisis. The EU as a whole faces a pivotal summit on February 18/19th with some form of deal essential. There has been increased criticism of Greece and Italy and reports that the Schengen agreement for open borders within the EU could be suspended for two years. There have been strong warnings that any suspension would aggravate tensions between the Northern and Southern states.
There have been renewed fears surrounding the banking sector with a focus on Deutsche Bank and its 'CoCo' bonds while the Italian banking sector is continuing to weaken. Vulnerability in the sector will tend to jeopardize improvement in monetary conditions and improved transmission mechanism seen over the past few year.
The ECB could cut the deposit rate deeper into negative territory, but this would risk further eroding banking-sector profitability and prove counter-productive. It is easy to imagine how intensive the banking sector lobbying will be ahead of March's ECB meeting.
The ECB could certainly expand the quantitative easing program further and expand the range of assets purchased, although any move into even more controversial areas such as banking-sector bonds would trigger open revolt within the council. In this context, there is again a risk that the ECB will disappoint market expectations with the Euro moving higher once again.
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