Tags: euro | ECB | China | dollar

Trade-Weighted Euro Might Be Set for Shock Upswing in 2015

Sunday, 28 Dec 2014 10:35 AM

While investors are betting the euro will fall against the dollar next year, hopes that the European economy will therefore get a boost could be premature: it may not depreciate at all against currencies of other major trading partners.

As speculation grows that the European Central Bank will ease monetary policy more aggressively, some economists predict the euro could even slide to parity with the dollar by the end of 2015 from around $1.22 now.

However, the dollar is no longer the most important element in the ECB's trade-weighted euro index, its favored gauge of the euro's strength. That position is now held by the yuan and against the Chinese currency — along with others such as sterling, the Swiss franc and Japanese yen — the euro's prospects are far from clear.

The euro has already lost around 3 percent against the dollar since early October when the ECB said it would buy rebundled packets of debt, as it tries to fight off the threat of deflation in the euro zone.

Expectations are strong that the ECB will move on to quantitative easing next year by buying government bonds. This would involve printing money in the hope of pushing inflation that is close to zero towards its target of just under 2 percent, a policy that should weaken the euro.

The ECB reckons that a 10 percent fall in the euro's effective exchange rate would deliver 40 to 50 basis points of much-needed inflation to the euro zone. However, the euro has actually gained around a third of a percent on a trade-weighted basis since October.

China is now the eurozone's biggest trading partner, and the common currency has held steady against the yuan over the past month while it has fallen 1.5 percent against the dollar. 

Any euro rise against the yuan would effectively import disinflation from China, hurting the ECB in its campaign to avoid the kind of deflation that has hit the Japanese economy so badly in the past decade.

The U.S. economy is expected to grow strongly in 2015, prompting the Federal Reserve to start raising interest rates and thereby boosting the dollar, but the outlook for China and its currency is far less clear.

"The potential for the yuan to become more volatile next year is certainly there," said Paul Lambert, head of currency at Insight Investment. "There are certainly scenarios in which the yuan would weaken."

Saxo Bank Chief Economist Steen Jakobsen reckons the yuan will fall at least 5 percent against the dollar next year as the Chinese economy slows.

RACE TO THE BOTTOM

Many economists argue that the main way for an ECB program of quantitative easing to work would be through weakening the euro, but this may be tricky to achieve.

Among other constituents in the ECB basket, third-ranked sterling can expect a bumpy year, with Britain facing its most uncertain parliamentary election in decades in May.

The euro may also struggle to weaken against the Japanese yen and the Swiss franc, ranked four and five respectively.

The Bank of Japan recently expanded its own program to stimulate the domestic economy, while the Swiss National Bank has promised for the past three years to cap the franc at 1.20 per euro. Earlier this month, the SNB also said it would start charging banks for deposits in francs for the first time since the 1970s, hoping to ease upwards pressure on the currency.

Stephen Gallo, European head of FX strategy at BMO Capital Markets, said that furthermore, the euro would remain structurally strong, helped by the euro zone's current account surplus. ECB measures that would, for example, revitalize the asset-backed securities market, could attract foreign interest, further supporting the common currency.

"Rather than seeing huge capital outflows because the ECB is offering cheap liquidity ... you could actually get a decent amount of interest in euro-denominated asset markets," he said. "Liberating the capital markets in the euro zone should be positive for the euro."

Most of the other constituents in the euro index are other European currencies, heavily exposed to the euro zone economy and from countries with very low inflation. According to Toscafund's chief economist Savvas Savouri, many of them are set to fall sharply against the euro in 2015.

"It's not just the dollar against the euro that matters," said Savouri. "It's the zloty, it's the Czech crown, it's the Croatian kuna against the euro."

© 2017 Thomson/Reuters. All rights reserved.

   
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While investors are betting the euro will fall against the dollar next year, hopes that the European economy will therefore get a boost could be premature: it may not depreciate at all against currencies of other major trading partners.
euro, ECB, China, dollar
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2014-35-28
Sunday, 28 Dec 2014 10:35 AM
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