Here Is Why The ECB Can't Weaken The EUR - Morgan Stanley

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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.

The EMU’s disruptively high real rates could not only undermine fixed asset investment prospects within EMU they may also take the EUR into overvalued territory.

The 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 FX levels.

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.