What's up with the euro?
If
you've been following the currency markets lately, you may have noticed
something very odd: the euro just keeps marching higher. That's right,
the euro - the same currency whose very existence was the subject of
debate just two years ago - is now testing the 1.40 mark vs. USD, a
level it has not seen since 2011. How could this be? Why does the euro
continue to march higher despite the ongoing economic malaise in the
18-member currency bloc (not to mention the ongoing tensions over
Ukraine)? And what about our repeated calls for a euro correction?
First, let us provide some background as to the recent euro strength.
For
nearly half a year now, the Eurozone economy has been sending mixed
signals. On the positive side, the region emerged from recession last
summer, and manufacturer confidence (using PMI indicators as a proxy)
has dramatically improved. However, belying the upturn in growth and
confidence was a dramatic slide in the region's inflation rate, kindling
fears of deflation. Any deflationary environment would be a threat to
the Euro region's nascent recovery, as consumers and businesses alike
would have an incentive to put off purchases and investments until
later. A prolonged, Japan-style stagnation seemed like a real
possibility.
Faced
with the threat of deflation, a central bank's usual course of action
would be to loosen credit conditions - through a combination of rate
cuts, asset purchases, or direct lending facilities to banks. Or in
plain English: pump more money into the system. For some time now, a non-trivial number of economists and market commentators - including Red Bull -
have called for the European Central Bank to do just that. We, like
many others, believed it would be downright foolish to allow ultra-low
inflation to threaten the green shoots of recovery.
The ECB doesn't seem to agree. Rather, the most
they've done is sporadic verbal jawboning about the need to consider
additional measures. They're deploying the pea shooter at a time when a
bazooka is needed. And at last Thursday's ECB board meeting, the bank's
president, Mario Draghi, even suggested that the risk of deflation has
receded (even though the annual inflation rate, at 0.8 percent, is less
than half of the 2 percent level that the ECB itself defines as price
stability). Whether or not Draghi knows something that we don't, we
can't tell. But the ECB's continued inaction has been enough to drive the euro back to two-and-a-half year highs.
So what about our bearish view on the euro? We'll be
the first to admit that our call for a correction in the EUR has been
premature. We, like many others, have underestimated the degree to which
the FX markets have been willing to play along with the ECB's game. But
our central thesis remains intact: with unemployment across the euro
region stuck at 12 percent, small- and medium enterprises in Italy and
Spain still largely unable to tap cheaper credit, and growth levels
still nowhere near escape velocity, the ECB cannot remain in a state of denial forever. At
some point, another dose of monetary stimulus will be needed, if the
Eurozone is to have a reasonable chance of returning to economic
normalcy. So while we're not calling for investors to unleash their
shorts on the euro, chasing it higher will also likely do more harm than
good. The bottom line: don't use the recent euro currency strength as a vote of confidence in the Eurozone economy just yet.
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