Macro: The Bottom Line (5/12/2014)

A long overdue wake-up call for euro bulls

 

Lest you thought we've gone radio-silent on our bearish stance toward the euro: we'll be the first to admit that shorting the common currency wouldn't have been the best trade over the past few months. Despite all the fundamental factors suggesting otherwise (which we'll reintroduce shortly), the currency through the start of May continued its inexorable march toward $1.40.

This past week, however, the euro seemed to lose steam. After attempting yet another run for the $1.40 mark, the currency made a rather hasty retreat to below $1.38. The main factor behind the rally was the ECB policy meeting on Thursday. While there were no policy changes, ECB President Draghi's comments were clearly on the dovish side, suggesting the bank could take action as soon as next month. 

In our view, this mini-correction in the euro is long overdue, and may be the start of a more pronounced slide going forward.

 

Before delving into the reasons why, let's put things into context. This was definitely not the first time in 2014 that Draghi has threatened to open the monetary floodgates further; he did that quite explicitly back in February as well. And euro bulls will be the first to point out that this supposed "call to action" in February amounted to little more than three months of inaction. But we think there are compelling reasons to think that this time, things will be different.

The risk of deflation has increased since February: If you recall, one of the main reasons why the ECB has come under pressure to loosen policy has been the ultra-low inflation rates in the Eurozone. The worry is that, with prices increasing at such a modest pace, there'd be an incentive for European consumers and firms to save rather than spend or pursue capital investment. Eventually, if too many economic agents postpone their spending, inflation could slip into negative territory, which would distort incentives even further, as happened in Japan. And if the last few months' economic data is any guide, the risk of such a deflationary scenario has increased. For instance, the latest figures released at the end of April showed that inflation in Spain continues to hover dangerously close to the zero mark, and that in Germany (the Eurozone's strongest economy) it remains close to 4-year lows. Add to the mix the prospect of fiscal retrenchment in France (where the government has just announced 50 billion euros of spending cuts), and you have a recipe for stagnation. Draghi would be remiss to ignore the creeping danger from these developments.

The ECB has become more outspoken about the exchange rate: In February, the euro traded around $1.35, and Draghi was conspicuously silent. But once it came close to breaching $1.40, he blinked. Since then, Draghi along with his colleagues on the ECB Governing Council have been notably more vocal about the dangers of a strong currency to the region's nascent economic recovery. After all, we should not forget that the recent improvements in peripheral countries such as Spain and Portugal have been driven in large part by exports. The ECB would be loath to jeopardize the "green shoots" it has spent so much effort cultivating. In fact, all indications are that the ECB is setting an implicit comfort limit at $1.40 (with an absolute red line at $1.45). Any drive toward those levels could lead to some aggressive jawboning or even intervention.

There's a growing consensus within the ECB for unconventional measures: Part of the reason why the ECB has been so restrained in pursuing stimulus compared to the Fed or Bank of Japan - and by extension, part of the reason why the euro has been so resilient - has been opposition within the ECB board. In particular, the "northern clique" led by Germany has been dogmatically allergic to any suggestion of QE or asset purchases, and has had sufficient influence to tie Draghi's hands. But with the situation showing no signs of turning - either on the inflation or the exchange rate front - these objectors have increasingly found themselves in the minority. So much so that now even the Germans appear to have jumped onto the "unconventional measures" bandwagon - Draghi was even able to announce in April that ECB policymakers were "unanimous" in considering more aggressive measures. And he repeated that very line last Thursday as well.

For the three reasons above, we see a non-trivial chance that the ECB could (finally) act in the near future. When it does, it would refocus attention on the divergence between the ECB's loosening bias and the Fed's moves toward reducing stimulus. It may be time for the euro bulls to start considering their own exit strategies.