Euro outlook remains challenging even as break-up fears recede

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After another annus horribilis for Europe in 2012, there has been a gradual but steady improvement in market sentiment this year. Although the growth outlook still looks weak, there has at least been some respite from the relentless worry about debt default and euro break-up.

The dissipation of Europe’s cloud of negativity has put the continent broadly in line with the rest of the world, easing the downward pressure on the euro. Retreating fears for the single currency has left a vacuum that has been filled by concern about the roadmap to banking union and growth.

“More European investors now see the withdrawal of central bank stimulus as a bigger risk to European credit markets than eurozone sovereign debt problems,” says Fitch, commenting on the results of its Q3 investor survey. “But most believe central banks will tighten policy without threatening the economic recovery.”

Although few would bet against further political drama, and the risk of a deterioration of the situation in Greece remains, this is indicative of an emerging optimism in Europe.

The Commodity Futures Trading Commission’s Commitments of Traders’ report shows sentiment among non-commercials and speculators on the euro is at its most bullish since May 2011, when the EUR/USD traded above $1.5000, notes Christopher Vecchio, currency analyst at DailyFX.

More recently, global attention has shifted to the US as fear mounts that the federal government shutdown could prove more than a temporary aberration.

Markets have remained relatively calm, just as they did following Silvio Berlusconi’s attempt to hold the Italian government to ransom. A year or two ago, such shenanigans would have triggered dramatic moves in the credit markets. This is a sign of returning European stability.

“The worst of the European crisis is now behind us and the ECB, EU and IMF have made it pretty clear they won’t let any government fail,” says Robb Reinhold, senior FX trader at Maverick Trading.

This is positive for the euro – though that optimism comes with a heavy dose of caution.

“The economic backdrop doesn’t look that great and I can see there being a decade or two of slow growth in Europe,” warns Reinhold.

“A weak USD is typically a good thing for the euro and we have already seen that movement taking place as the government shutdown continues. During the last month, the EUR/USD has gone from 1.3150 to 1.3550.

“The AUD has been the best currency to trade against the EUR, as that has been where the volatility is.”

The first six months of the year saw the aussie get hammered in the market, losing 10% to 15% against most currencies, due largely to the slowdown in China, the largest consumer of Australian resources.

During that time, the EUR/AUD went from 1.22 to almost 1.50, an appreciation of more than 31%. “That is a huge gain in the currency markets where most currencies are trading in a range of +/-10% all year,” says Reinhold.

However, lately that trend has reversed, with the aussie strengthening – though as the euro has also been strengthening against most currencies, the trade between the two is less profitable than it was.

Looking ahead, one currency the euro might appreciate against is the yen, with the Bank of Japan the only leading central bank more dovish than the ECB. Its goal is to double the money supply in a year to finish in the spring of 2014 – a massive stimulus.

Although the initial shock has now been priced into yen in terms of dramatic moves, this still points to a weakening Japanese currency in the longer term.

For currency traders, the question is: will the euro fare better or worse than other currencies in a world where growth is sluggish generally, not just in Europe? On this there is little consensus, except that what moves there are should be gradual.

“If we have a weak decade of global growth then the euro could actually do fairly well, since it may look better than the alternatives,” says Maverick Trading’s Reinhold.

He believes this scenario would probably see the euro holding its value without necessarily strengthening markedly. “Overall, I’m pretty neutral longer term for the prospects of the euro,” he says.

Ilya Spivak, currency strategist at DailyFX, adds: “In the medium term, euro sentiment will be driven by monetary policy, and compared to the Fed and the Bank of England, the ECB looks dovish.”

While the Fed looks to taper its quantitative easing and the BoE has also hinted at the limits of its action by offering guidance for its eventual retreat, the ECB has indicated it will keep its monetary policy at current levels or easier.

That sets the euro on a path to relative weakness against the dollar and sterling, a long-term structural decline that will continue throughout next year, predicts Spivak.

“The move will be large,” he says. “Not fast, but steady. Europe’s growth is dependent on exports, so it knows what it has to do. That is not to say the ECB will target rates overtly – it doesn’t need to. Monetary policy is doing the work for it.”