Citi: Why Does The Euro Refuse To Go Lower?

Tyler Durden's picture

Contrary to most consensus views (including Citi's FX technical group) EURUSD has failed to move lower in 2014. Why?

Via Citi's FX Technicals group,

We think there are some valid arguments which fit very well with the historic dynamic seen in 1997-1998.

If so then it still remains only a matter of time before market dynamics will reach a point where EURUSD once again makes a strong move to the downside.

EURUSD long term chart

The long term EURUSD chart shows the similarities with that seen in the last USD cycle throughout the 1990’s

Both rallies were similar in length as were the background economic dynamics (housing boom and subsequent bust in the US in the early 1990’s and again in 2006-2007)

The highs came in 1992 and 2008 and the major developments that followed three years after each of those highs was a currency crisis in Europe – ERM crisis in 1995 and the European Sovereign debt markets crisis in 2011.

Within the bear market for EURUSD that came after 1995 we can see there was a decent correction up from August 1997 into October 1998 which saw EURUSD bounce 16.5%

Since the low posted at 1.2043 in July 2012, EURUSD has bounced 16% so far.

As a consequence we believe an important peak has either been put in place or is coming relatively soon which would mark a turning point that is likely to send EURUSD back to the 200 month moving average at 1.2134

A monthly close below that 200 month moving average (which has limited the three major falls in EURUSD over the past 10 years) would then open the way for much lower levels still over time (Possibly to parity or below over the next 2-3 years)

EURUSD 1995-1998 and 2011-2014 - Not identical but pretty similar

...

Euro monetary conditions index as at Dec 2013.

MCI: Monetary conditions index: This peaked in Aug 2012 (Loosest point of the MCI cycle which started easing in Feb 2008).

RIR: Real interest rate: Also eased dramatically since 2008 and was loosest around the same time as the MCI was at its high. It has since marginally contributed to a tighter MCI.

REER: Real effective exchange rate: Has moved down totally in tandem with the MCI. In Feb 2008 EURUSD was at 1.6020 and peaked at 1.6040 in July. In July 2012 it was at 1.2043. It hit 1.3967 (16% rise by March 2014 having been at 1.3893 in Dec 2013, the last month with this data.

It is clear from the chart above that the overwhelming contribution to tighter monetary conditions has been the exchange rate followed by falling inflation (Causing real interest rates to rise) and that Europe now desperately needs a weaker currency to help stimulate the monetary conditions gain.

After Draghi came out with the rhetoric of “we will do what is needed to preserve the Euro and it will be enough” (July 2012) EURUSD unfortunately did exactly the opposite of what was needed and has rallied 16% since that month. Now despite repeated rhetoric (In a misguided attempt to avoid action) designed to stop the Euro moving higher it remains at exactly the same level as it was at in December 2013 when the data above was last made available. (Remember 2008 when EURUSD peaked at 1.6020 and then at 1.6040 3 months later before turning)

So what can they do? As Cit explains below in considerable detail, not much . At best the psychological effect of moving from negative real rates to negative nominal rates accompanied by a statement that the strength of the EURO is tightening monetary conditions and increasing the deflationary risks might be sufficient to turn the currency lower.

There is also a sea of opinion that says a recessionary European economy with deflation and a high current account surplus is reminiscent of Japan and would likely send the Euro higher .We agree on the concerns about the outlook but not the conclusion

Japan was and is one economy with one bond market and a central fiscal system. Europe is a gathering of separate countries with different bond and fiscal systems and no fiscal transfer mechanism.

 

In tough times Japan tends to act together like “Japan Inc.” while Europe gets territorial and Nationalist

 

Japan’s current account surpluses were Japan’s surpluses. Germany is the primary surplus nation in the Eurozone and it is not likely to be “gifting” those surpluses externally anytime soon. When it comes to the periphery recent surpluses are more to do with falling imports than economic health.

 

Japan has one banking system. Europe cannot even agree on a pan European bank deposit guarantee system.

 

As the backdrop deteriorated in Japan they moved to a QE approach which they have revisited recently but they did not default despite rising debt levels and financed that debt predominately internally. When the backdrop deteriorates in Europe they “take your money” through default and deposit confiscation. (Neither of which policies they rule out going forward). This default without devaluation fails to economically stimulate especially as it is accompanied by austerity measures.

 

This suggests that the Euro goes down as part of the solution (Good weakness and our preferred and likely scenario) or as a renewed part of the problem (Bad weakness, economic and political fragmentation, social discord, haircuts and confiscations which would almost certainly result in the ultimate demise of the Euro). This is neither our preferred or expected scenario but more of a tail risk event.

Conclusion:

We are no less convinced than we were at the start of the year that EURUSD is going to head much lower over the coming years

We anticipated this move would already have begun at this stage yet we sit at almost the exact level where we closed 2013

We believe the “day of reckoning” is not far away and that as detailed above the building blocks are now falling in place. We may have already peaked with the marginal new high posted at 1.3967 this month but either way we are skeptical of any sustainable move over 1.40 materialising and still believe that we may see EURUSD much closer to 1.20 than 1.40 before this year is behind us.

 

Full note below:

Weekly Roundup - Why Does the EURO Refuse to Go Lower 1440391-2