EUR to Spring a Surprise on Markets?

The euro performed well in 2017, but can it keep going? Galen Stops suggests that political factors mean that this currency could surprise markets in 2018.

This time last year, the European Union was still grappling with the fact that one of its biggest members was poised to leave the club, people were nervous about a populist, anti-EU party winning the Dutch general election, and even more nervous about a populist, anti-EU party winning the French election and presidency.

As a result, markets were – understandably – pricing a lot of risk into the Eurozone.

Obviously, Britain did trigger Article 50 to begin the process of leaving the EU, but since then, Brussels has seemed to hold the upper hand in the subsequent negotiations. Meanwhile, Europe breathed a sigh of relief as the centre-right VVD party won by a comfortable margin in Holland and Emmanuel Macron and his La Re?publique En Marche party managed the same feat in France.

In addition to this, the euro area economy grew at its fastest pace in a decade in 2017 with the European Commission forecasting GDP growth at 2.2% at the back end of last year.

Judging by the euro rally in the second half of 2017, markets took this to mean that all political risk had evaporated from the Eurozone and all was well within the group once more.

Analysts at ING put EUR in their “Sweet Spot” in their 2018 FX Outlook, arguing that subdued policy uncertainty, ongoing support to the global recovery from liquidity conditions and a rotation into investment stories will create an environment that will be beneficial to the currency this year.

“Another year of strong growth in the Eurozone should allow EUR/USD to work its way towards 1.30, even though the US economy may be growing quite nicely,” they predict.

George Saravelos, a strategist at Deutsche Bank in London, agrees with this assessment stating: “As 2018 unfolds, the market will grapple between duelling US and euro reflation forces. We belive European forces will win out and would buy EUR/USD targeting 1.30.”

Not everyone is convinced by this rosy outlook though.

“Our hypothesis for 2018 is that the euro euphoria built up in 2017 will not continue. The negative feedback loop of a strong currency weighing on the economic outlook will become apparent for the Eurozone in 2018 and drive the EUR/USD lower to levels around 1.14,” says David Kohl, chief currency strategist at Julius Baer.

Perhaps even more problematic than a strong currency is that there are still some potential political headwinds in Europe that the currency markets seem to be ignoring right now.

“While the political risk has certainly diminished, the amount that the euro has rallied is, to me, inconsistent with the diminishment of political risk. Certainly, the economics have been better in Europe and that would, in part, have contributed to part of the euro’s rally, but I think that the market has got too far over their own skis on that trade and there’s still some substantial political risk in the EU,” says the global head of currency management at one large US asset manager.

For starters, it feels these days like Europe is only ever about one Italian bank collapsing away from a full-blown crisis. And speaking of Italy, 2018 brings the next round of consequential elections for the European Union.

The Italian general election is due to be held on March 4 and currently, Italy’s Five Star Movement – a eurosceptic party that has long talked about leaving the euro – is the country’s most popular individual party in the polls. Now, a coalition of other parties might still be able to beat the Five Star Movement, but there is still clearly big EUR risk left on the table.

“Clearly, Germany and France are the two most important players in Europe, but Italy is just a notch below and it would be quite significant if you have that large a participant in the Eurozone project become much more sceptical about it,” says the global currency head.

Another factor to consider is that the political reality in Germany has changed following its election last year. Although Angela Merkel won a fourth term as Chancellor, her authority has seemingly been diminished, the radical right-wing AfD has entered parliament as the third-largest party and – at the time of writing – a new governing coalition has still not been formed. All of which arguably reduces the political stability of the Eurozone heading into 2018.

It might be that the Eurozone manages to avoid political drama this year but, being the Eurozone, that seems unlikely. A more probable scenario is that markets will get slightly spooked as the Italian election nears and will begin to price more risk into EUR. The currency might recover some of its value in the second half of the year, but 1.30 seems somewhat optimistic.

Galen Stops

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