After the abysmal March payrolls last Friday, the EUR briefly spiked only to lose all of its gains over the next two several days and then some. And if SocGen is correct, the European currency has much more room to fall. The reasons are not new, recapping what is already widely known, however those wondering why the EURUSD just took out its low stops for the day, the following 4 reasons from SocGen's Patrick Legland should be a useful refresher why Euro parity may be coming faster than most think.
Reason 1: strong bond outflows set to continue
In Q1 15, the euro depreciated against all major currencies (JPY, GBP etc.). Having dropped sharply since May 2014 (-22%), the EUR/USD is now tracking relative yields more closely (see chart). With disappointing US economic data in Q1 – including nonfarm payrolls well below expectations last week (126k) – the EUR/USD could remain range-bound near term, as markets are pricing in a slower pace of rate hikes by the Fed. But the desynchronisation of central bank policies is a long-term theme, with euro rates expected to stay low, while US and UK rates should rise in the medium term. With eurozone yields stuck at extremely low levels, investors must reallocate their investments into higher-yielding assets, in part overseas. Given the large amount of maturing European principals and coupons to be reinvested in 2015 (c.€1.15trn), this could lead to strong outflows over the next quarters and weigh on the euro.
Reason 2: Lingering political risks on Greece and Spain
On 20 February, the Eurogroup agreed to extend the Greek programme until late June and to provide €7.2bn of new funding to Greece on condition that the government passes economic reforms by the end of April. The country is running out of cash but faces only small repayments before the summer, while sizeable payments are due from 20 July onwards. According to our Rates strategists this could lead to continued brinkmanship for some months yet, but no significant change in the status quo. As a result, Greek banks will remain under pressure, as illustrated by the acceleration of deposit outflows (see chart). Our economists’ base case is still that a solution will be found to kick the can further down the road, but the risk of a “Grexit” is not negligible. In Spain, the electoral marathon, which started last month, could increase political instability, with Podemos’ progress to be monitored.
Reason 3: EUR losing its reserve status
- IMF COFER data released last week shows a further drop in official foreign reserves allocated in euro in Q4 2014.
- Since the euro crisis, the currency has been losing some of its reserve status and reserve managers have been looking to diversify their foreign reserves out of the euro.
- This trend is likely to continue due to ongoing political risk and aggressive ECB easing, making the currency unattractive.
Reason 4: ECB likely to extend easing beyond 2016
- The eurozone is enjoying the tailwinds from cheap oil, a weak euro, improving financial conditions, and looser fiscal policy. But, given the still-significant need for deleveraging and reform, these short-term tailwinds may not result in a self-sustained recovery.
- Consequently, our economists expect ECB asset purchases to continue beyond September 2016 if the inflation outlook does not improve.
- In their baseline scenario, they expect the ECB to also add corporate bonds to its asset purchases in 2016 (to support the supply of assets), and extend QE and the TLTRO programme by around one year to mid-2017 (adding an additional €600bn to its balance sheet).
With these major drivers, our FX strategists expect the EUR/USD to depreciate further in 2015, and reach parity by March 2016. How this impacts equity markets will depend on the dominant force behind the fall in the currency. The weaker euro and lower rates resulting from ECB policy should benefit international companies. But if the euro’s depreciation is driven by the perception of heightened political risk, stocks could be negatively impacted. The recent rise in eurozone implied equity volatility in March could accelerate if Grexit fears intensify. Grexit or not, further progress on euro area integration and governance is needed to go from a fixed currency system to a “Genuine Economic and Monetary Union” and reassure investors about the region’s long-term prospects.