In the past three weeks, we have seen a bit of ‘a perfect storm’ against our call for a weak Euro. Hawkish comments from the ECB President Draghi on the limited room the central bank has to further cut the interest rate, a stronger-than-expected Euro area inflation print, a dovish FOMC meeting and Chair Yellen’s recent speech, and increasing concerns around the outcome of the upcoming referendum on the UK’s membership in the European Union have pushed the EUR higher versus the USD and the GBP by about 3.5%.
The strong employment report released this past Friday has not been enough to halt this trend and it is unlikely that strong US data will lead the EUR down, unless they are accompanied by more hawkish speeches from the FOMC leadership.
Our US economists expect that the Fed will increase the federal funds rate in June, in which case the April FOMC meeting could be the event used to begin preparing investors for the next hike. Until then, it is likely that the Euro continues to trade around the current range.
But, setting aside developments in the US and the divergence of monetary policies, which underpins our view on the EUR weakness, the coming months are not short of political events, which can be quite negative for the EUR.
In our view, risks related to such events are underpriced and could lead to a significant depreciation of the currency as they get re-priced and more so if they materialise.
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1- Long Euro: a poor risk-reward “Brexit” trade
First, as we have written in Sterling: A ''Fashionable'' and ''Actionable'' Currency in 2016, playing a “Brexit” view against the EUR is not our preferred implementation of our weak Sterling view. In fact, if Brexit becomes a reality, it would not be good news for the rest of Europe either, in our view. Markets would begin to question whether a referendum to leave to the European Union or the Euro area could be called in another member state. It is not inconceivable that investors would decide to sell Euro area assets as a result. If the UK voters choose to remain members of the European Union, then the FX market would have to catch up to price a more hawkish Bank of England and a tightening cycle that begins earlier and progresses faster than discounted in the forwards. On our forecast, we expect 15% Sterling upside over a 12-month period.
2- “Grexit” headlines: a come back
Second, there is once again news on tensions among the IMF, Germany and Greece, which are likely to intensify as we get close to 20 July, when Greece faces again a redemption to the ECB of EUR 2.2bn. The IMF continues to call for a sizeable debt relief and it is questioning again its participation in the Greek program and delaying the conclusion of the review. But a sizeable debt relief to Greece remains politically unacceptable in Germany and many other Euro area countries. While Greece has not been a systemic risk for the Euro area in a long time and such a debate is no news for investors, it is still important to keep in mind that political tensions are likely to intensify in coming month. As negotiations drag on and negative headlines increase, this could be a reason to keep investors temporarily away from the currency later on in Q2.