The Euro has confounded many analysts who had dusted off their extrapolators and projected a continued decline of the currency through parity with the US dollar. Despite the increasing probability of a Federal Reserve rate hike, a possible Greek debt default, and a UK election outcome that put a referendum on EU membership on the table, the Euro has bounced off its early 2015 lows against the US dollar (Figure 1). What has changed?
The healthy US employment data for May strongly reinforced the expectation that the Fed will decide to abandon its near zero-rate federal funds policy and take the first baby step toward higher short-term rates. Conventional wisdom suggests that a rate hike will strengthen the US dollar. Financial markets, however, are discounting machines; everyone and his dog have gotten the email that a rate hike is likely, even if the timing is uncertain. Consequently, a good case can be made that the impact of any rate increase is already 120% discounted in the dollar/euro exchange rate. Further euro weakness would require something unexpected to change the fundamentals.
Despite the increasing probability of a Federal Reserve rate hike, a possible Greek debt default, and a UK election outcome...the Euro has bounced off its early 2015 lows against the US dollar. What has changed?Without credit growth, economies stagnate, and Europe has not had any credit growth for years. One of the unintended consequences of the stress tests on European banks conducted in 2013-2014 by the European Central Bank (ECB) was that banks focused on balance sheet clean-up activities and not expanding their loan base (Figure 2). Indeed, most bankers decided that the best way to pass the stress tests was to repay “emergency liquidity loans” given by the ECB to the banking system during the sovereign debt crisis. As a result, the ECB was the only major central bank whose assets shrank in 2013-2014 – declining by a whopping EUR 966 billion between end-2012 and October 2014, when the test results were finalized and announced. With the stress tests over, credit growth may resume, especially since the relatively lower value of the Euro has given exporters a chance to grow sales. This is a positive development for the Euro, but one not well anticipated or properly appreciated by markets.
While even modestly positive economic growth encouraged by healthier credit markets supports a stronger Euro, there are two internal risks that require examination – the possibility of a Greek default or exit from the Euro, and the implications for future EU relations from the resounding Conservative Party victory in the May 2015 UK elections.
As for Greece, the key point to remember is that the ECB was created specifically to safeguard the Euro, and ECB President Mario Draghi is on record as willing “to do whatever it takes.” He has tremendous resources at his disposal, so even if there is a Greek debt default or Greece leaves the Euro, outside of some short-term volatility, the ECB can be expected to serve as backstop so that any distress in European financial markets would be countered aggressively. Indeed, the Euro would probably rally on a Grexit event. In corporate finance, it is well documented that cutting your losses can lead to higher stock prices.
The UK-EU relationship is much more complex. The UK economy needs easy access to European markets, and Europe depends much more on the efficiencies of the London-based financial markets than it might like to admit. Nevertheless, public sentiment in the UK tends to run negative on the EU. Thus, it is entirely possible that when/if a referendum is held in the UK, a negative vote may occur. The vote will be non-binding, but even the possibility of a negative vote has given Prime Minister David Cameron considerable leverage in re-negotiating Britain’s role in the EU and protecting London’s financial markets from EU regulations. More comfortable and less contentious UK-EU relations might help both the Pound and the Euro.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Bluford “Blu” Putnam has served as Managing Director and Chief Economist of CME Group since May 2011. With more than 35 years of experience in the financial services industry and concentrations in central banking, investment research, and portfolio management, Blu serves as CME Group’s spokesperson on global economic conditions.
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