The new year gives investors a chance to take stock and make plans for the months ahead. For currency traders, one of the prominent themes of 2012 was just how little EURUSD moved given the turmoil in the eurozone.
EURUSD now stands just 1% higher than at the end of 2011. The average level in 2012 was $1.29, down from $1.39 in 2011. From high to low, EURUSD saw its smallest annual range since 2001 last year and its smallest annual change ever.
That is not much of a range given that Mario Draghi, European Central Bank (ECB) president, was forced over the summer to pledge to do whatever it takes to ensure the survival of the EUR in the summer, as doubts mounted over the very existence of the single currency.
Furthermore, the dynamics of EURUSD, which has traditionally been primarily driven by relative interest rates, shifted as the Federal Reserve and the ECB both eased monetary policy to ultra-loose levels.
Indeed, Kit Juckes, head of FX strategy at Société Générale, says if there was a story about relative rates, it is that the two-year rate spread between the US and the eurozone stopped mattering for the path of EURUSD last summer. It was replaced as the prime driver of EURUSD by measures of eurozone sovereign risk for example, the spread of the yields on three-year Spanish bonds over their German counterparts.
|Source: SG Cross Asset Research|
On this basis, says Juckes, the big question for the first quarter is how much further the Bono/Bund spread can narrow on the back of a resurgence of global risk-on sentiment, while the longer-term questions are whether the eurozone sovereign debt crisis resurfaces and when relative economic divergence between the US and Europe translates into renewed interest-rate divergence.
The ECB left its refinancing rate unchanged at its December meeting, saying that risks to inflation were balanced. That suggests that interest rates will remain unchanged at its January meeting. However, there were calls from ECB board members from peripheral eurozone countries for a further cut in rates, suggesting the prospect of a rate cut cannot be excluded.
An ECB rate cut for the benefit of peripheral economies might provoke a knee-jerk sell-off in EURUSD, but it might be that no action from the central bank could be more significant from a currency perspective.
Interestingly, by keeping rates unchanged, the ECB could provide the catalyst for an upsurge in volatility in EURUSD and a sharp move lower in the single currency as tensions in the eurozone financial system escalate.
As Hans Redeker, head of FX strategy at Morgan Stanley, points out, it is not just the weak performance of the eurozone economy that requires further easing of monetary conditions, but also the regions banking sector.
He notes eurozone banks, particularly in the core, face declining market-funding costs, reducing their incentive to hold on to LTRO funding.
According to data from Fitch, for example, US-based money-market funds increased their exposure to eurozone banks by 6% in November. Core European banks were the main recipient of those funding flows, however, with German banks seeing a 26% increase in money-market inflows.
Some banks have already made official announcements that they are considering repaying LTRO funds in early 2013, says Redeker. The problem is when core banks repay LTRO funds, this will stigmatize the other banks, which face higher funding costs and run weaker balance sheets.
Therefore, once stronger banks start repaying their LTRO funds, weaker banks who keep LTRO funding might find the market becomes reluctant to do business with them.
Indeed, should the ECB delay a rate cut and prompt stronger banks to repay LTRO funds, other banks will not want to be seen as remaining dependent on central bank funding. Resulting peer pressure, therefore, could lead to an avalanche of LTRO repayments conducted even by banks with relatively weak balance sheets.
Weaker banks repaying LTRO funding could force them to shrink their balance sheets, leading the eurozone banking industry to seize up again, warns Redeker.
Those rising money-market tensions would have the potential to push investors out of risky assets, driving global risk appetite lower and pushing the USD sharply higher as investors rushed to the haven of the liquidity of the US currency.
Investors might not have long to wait for a renewed upsurge in currency volatility. After the torpor of 2012, EURUSD could be about to become more interesting.