Weak growth knocks some steam out of euro

The euro was the best performing of the major currencies in 2013, despite the fact that the ECB cut rates in May and November last year. 

It continued to perform well in the opening months of 2014.

More recently, though, it has been losing ground as the persistence of very weak growth in the eurozone, coupled with a fall in inflation to very low levels, forced the ECB into further policy easing this summer.

It has become increasingly clear that while interest rates look set to rise in the US and UK over the next couple of years, they will remain pegged at close to zero in the eurozone. This is putting downward pressure on the euro.

It has been a slow decline by the euro rather than a sharp drop. Against sterling, the euro has fallen from close to 84p in March to around 80p in the past couple of months. The euro/yen rate has fallen from 143 yen in April to 137 yen recently. Meantime, the euro has also moved steadily lower against the dollar over the past few months, falling from near $1.40 in May to $1.32. The move below €1.35 in July was particularly significant, as it took the euro out of the €1.35-1.40 trading range that it had occupied since last September.

The depreciation of the euro in recent months highlights the fact that an important factor for FX movements is the relative growth performances of economies and their inflation rates. These in turn are a major influence on the respective monetary policies of their central banks.

The outlook for the eurozone, US and UK economies and their monetary policies suggests that the euro is likely to lose further ground against the dollar and sterling. Monetary policy is set to remain very loose in the eurozone over the next couple of years, with interest rates remaining around zero, because of concerns about low inflation and only moderate growth.

Indeed, policy could be eased further with the ECB signalling that it may have to undertake unconventional policy measures, including quantitative easing, should it be necessary to further counteract deflationary risks. Meantime, the US and UK economies are gaining momentum and their labour markets continue to improve. The Federal Reserve and Bank of England have not been in any hurry to tighten monetary policy. They have also indicated that when rate hikes do eventually start to come through, they are likely to prove moderate.

Nevertheless, both central banks seem likely to increase rates next year, with markets expecting rates to rise to 2% by end of 2016/early 2017. In contrast, markets are not discounting any rise in eurozone rates until 2017 at the earliest. Thus, quite a gap is likely to open up between short-term rates in the US/UK and the eurozone. This points to further upside potential for the dollar and sterling against the euro.

It should be noted, though, that the euro has shown considerable resilience in the past couple of years, despite the pronounced weakness of the economy. There is also good technical support for the currency. It has not traded below 78p against sterling on a sustained basis since the collapse of the British currency in early 2008.

Meanwhile, although the euro dipped to around $1.20 against the dollar on a couple of occasions in recent years, these proved brief episodes. The euro has not traded below $1.27 on a sustained basis since 2006.

Meanwhile, $1.27-1.34 has been a common trading range for EUR/USD during the past five years. We expect that it will largely trade in this range in the coming months, unless we get large-scale QE from the ECB. Such a development could see a sustained fall by the euro to around the $1.20 level.