Euro - Depreciation Risks Remain

by: Citylytics

The US dollar remains the G10 currency with the highest yield.

Latest euro zone sentiment indicators suggest that growth turnaround is still not in sight.

The ECB is preparing the market for measures that could dampen the side effects of permanent negative interest rates on the banking system.

Given higher interest rates, the Fed unlike the ECB, has ammunition to dampen the negative effects of global growth slowdown.

The US dollar will keep its yield advantage versus euro for some time.

The USD index rose by more than 1% since mid-April and the EUR/USD is hovering slightly below the 1.12 mark since. The US dollar remains the G10 currency with the highest yield. However, this is not the only explanation for the recent dollar strength versus the euro. For a long time, the prospect of the first ECB interest rate hike had a positive effect on the euro. The market has now given up every hope of an ECB interest rate hike in near term and the euro therefore lacks an important factor that has supported it so far. As long as it can be expected that the US dollar yield advantage will continue, appreciation pressures on dollar will persist.

Chart 1: EUR and USD index movements (2017 = 100)

Source: Reuters

According to the preliminary flash estimate, the euro zone economy grew by 0.4% qoq in the first quarter of the year. While fears of recession have been reduced, it remains to be seen whether the period of weak growth has been overcome. Latest sentiment indicators suggest that turnaround is still not in sight. The purchasing managers' index for the service sector fell unexpectedly by 0.8 points to 52.5 in April. The index for the manufacturing sector, which is largely responsible for the weak growth in the past several quarters, rose only slightly from 47.5 to 47.8 after unexpected slump in March. The level of 50 points is considered to be the barrier that separates expansion from contraction.

Chart 2: EUR and USD index movements (2017 = 100)

Source: Reuters

The core inflation rate in the euro zone jumped by 0.4 percentage points to 1.2% in April. However, the rise is solely attributable to the fact that this year the Easter holiday-related price increase for package holidays took place in April and not, as in 2018, in March.

At its latest meeting in April, the ECB reiterated its intention to keep the key interest rates unchanged at least through the end of 2019, and in any case for as long as necessary to ensure the continued sustained convergence of inflation to levels that are below but close to,2% over the medium term.

Regarding the economic development, Draghi stated:

"The risks surrounding the euro area growth outlook remain tilted to the downside, on account of the persistence of uncertainties related to geopolitical factors, the threat of protectionism and vulnerabilities in emerging markets. The information that has become available since the last Governing Council meeting in early March confirms slower growth momentum extending into the current year."

A journalist asked Mario Draghi about the proposal of the Finnish Central Bank President Olli Rehn that the ECB should consider a strategy of price level targeting. In case of the latter, the ECB would only raise key interest rates once inflation had exceeded two percent for a while. This means that euro zone interest rates would stay at present lows for much longer than with the current inflation targeting strategy, which aims to prevent the inflation rate from rising above 2%. In response Draghi stated:

"The Fed is embarking on a revisitation of the monetary policy framework, and again, we have to see what's going to come out of that. These are not processes that can be discussed in one or two meetings, so it may take several months."

By stating the latter, Draghi not only failed to reject change in monetary policy strategy but also insinuated it is something that the ECB Council might consider.

In addition, Draghi stated during the conference:

"In the context of our regular assessment, we will also consider whether the preservation of the favorable implications of negative interest rates for the economy requires the mitigation of their possible side effects, if any, on bank intermediation."

The fact that the ECB is taking this into consideration shows that it is seriously considering a scenario where interest rates will stay at present lows for a prolonged period of time.

The US economy performed very well in the first quarter, especially when taking into account temporary government shutdown, trade conflicts and global growth slowdown. In the first quarter, the US economy expanded by 3.2% (annualized rate of change from previous quarter), which means that the growth even accelerated from 2.2% recorded in the fourth quarter of 2018.

Weak rise in the US employment in February intensified concerns about a recession. However, it was followed by above-expected employment growth in both March and April (March +189k, April +263k) that suggests that February was just an outlier. The jobs trend measured by the six-month average thus remains stable at around 200k per month. The employment of temporary help workers, a leading indicator for the economy, which has recently tended to weaken somewhat, posted the strongest increase since about two years ago in April. US unemployment rate (3.6%) has hit a low point that has not been reached for decades.

Chart 3: US - average employment growth (in thousands)

Source: Reuters

Chart 4: US - unemployment rate

Source: Reuters

While inflationary pressures in the US weakened somewhat in the recent period, the Fed stated at its latest meeting:

"Thus, our baseline view remains that, with a strong job market and continued growth, inflation will return to 2 percent over time and then be roughly symmetric around our longer-term objective."

The US dollar failed to depreciate even in times when the market was speculating about the possible interest rate cut. I actually believe that the latter is dollar supportive. The fact is that the Fed, contrary to other central banks, has scope to ease its monetary policy and dampen the negative effects of global growth slowdown for the US economy. The 2008 experience showed us that long US dollar positions are one of the few insurances the market has to offer. This means that even if the Fed will be forced to cut rates because of unexpected growth deterioration, more favorable prospects for the US economy will be more significant for the US dollar performance than temporarily declining interest rate differential between the US and euro zone. As euro area interest rates are already negative, the euro zone would face much worse economic future because it lacks the ammunition to combat the recession.

For a long time, the prospect of the first ECB interest rate hike had a positive effect on the euro. Not only that the ECB rate hike is no longer in sight, but also the ECB announced that it will introduce new TLTROs (long-term refinancing operations). As stated above, the ECB is preparing the market for measures that could dampen the side effects of permanent negative interest rates on the banking system. If it takes this into consideration, it becomes obvious that the central bankers are seriously considering such scenario. Even if the euro zone growth stabilizes, the ECB will certainly want to take its time before opting for an interest rate normalization. This means that the US dollar will keep its yield advantage versus euro for some time. The only scenario where euro might strengthen versus the US dollar is if the euro zone economy recovers to the point where monetary policy normalization can again be expected in the near term while US economic performance deteriorates at the same time. However, there aren't even the slightest indications of such development. With that being said, I believe that the EUR/USD still has a significant downward potential through the course of the year and that the fall below the 1.10 can be expected in the coming months.

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.