We maintain our bullish EUR view. A
higher Fed rate would likely support the USD vs. currencies sensitive
to front-end rate differentials. Generally, low-yielding currencies fall
into this category, but even here differentiation is required. The EUR and CHF should remain supported as
both regions have financial institutions with weak balance sheets and
so are unable to export sufficient local-currency-denominated long-term
capital to compensate for the current account surpluses. Resistance from
core EMU countries to more aggressive policies that could push
inflation rates higher should keep local real rates high, pushing the
EUR and CHF higher against most other currencies
Fiscal policy debate in the Eurozone. The EMU is not leading the debate about policies; instead, it lags.
Italy is considering more fiscal spending to deal with the devastating
damage to its infrastructure caused the recent earthquake, but that is
all we should expect to see. The EMU is not ready to remove the debt
brakes implemented in 2009, even if fiscal stimulus could boost the
economic outlook. A similar interpretation applies to the inflation
target discussion. All in all, the EMU's policy approach will not be
progressive enough to sufficiently boost its inflation
expectations,allowing its real rate levels to fall to a level that would
weaken the currency. Internally, the EMU may find it difficult to boost
inflation given the slack within its labor market, its poor corporate
profitability and weak financial institution balance sheets preventing
credit picking up.
Exhibit 10 shows the weak banking sector share price performance,
predicting weaker credit growth within the eurozone. A central-bank
induced liquidity impulse will find it difficult to develop multiplying
effects, but without improving credit demand inflation is unlikely
moving higher. International aspects have stayed deflationary too.
Commodity prices have rolled over and China's exchange rate adjusted
PPI,now falling at a 7.5%Y rate, does not bode well for the G-7 core
inflation outlook as illustrated in Exhibit 11.
EMU’s disruptively high real rates could not only undermine fixed asset
investment prospects within EMU they may also take the EUR into
EUR does not rise due to a better economic outcome within EMU. Instead
it may rise due to the lack of capital exports held back by balance
sheet constraints of EMU financial institutions and too high real EUR
rates allowing the recycling of EMU’s current account surplus at current
For now, the EUR may punch well above its economic weight. Due to the ‘exhausted’ position of EMU’s yield curve, there is very little the ECB can do to prevent EUR strength.