Euro may rise, if only so briefly, in 2016 as investors get out of other asset classes
As the euro is at root a political project driven by decades of support from centrist European governments, a logical assumption might be for the euro to weaken given that recent national elections across the euro zone have shown an erosion of popular support for established parties.
An additional issue might be whether the ever looser monetary policy settings adopted by the European Central Bank (ECB) continue to offer the prospect of adequate capital returns for investors that trump any concerns about political developments within the currency bloc and by extension weigh on the euro.
But there is another possible conclusion.
The euro might actually rise in value, at least initially, under this overall scenario as investors unpick positions across asset classes that have already incorporated, as a component part, having sold the euro as part of the initial investment strategy.
In recent years, positioning in euro-denominated assets has been largely driven by investors seeking profits via trades that exploit the opportunities offered by an ECB policy that is committed, in President Mario Draghi’s famous words, to do “whatever it takes” to safeguard the single currency.
That has translated into ever easier monetary policy settings including, now, a programme of asset purchases by the ECB.
Ever lower interest rates have encouraged investors to borrow in euros and invest the proceeds in government bonds issued by euro zone national governments. The chances of a capital gain on those bonds has only increased with the ECB’s own appearance as a buyer.
At the same time, investors bought euro zone equities on the rational assumption that ultra-low euro financing costs would push investors into stock markets in the currency bloc itself, seeking better returns.
But the logic did not just stop there.
The ECB’s ultra-accommodative monetary policy, by suppressing yields, made the euro less attractive than other currencies offering higher returns, thus weighing on its external value, graphically illustrated in the euro’s fall versus the yuan in 2014-15.
Consequently, investors buying euro-denominated bonds and equities hedged their currency risk by simultaneously selling euros on the foreign exchange market.
So, if investors decide that the potential for future capital gains on their euro-denominated bond and equity holdings is limited, those investors would not only have to sell those assets but also unwind their currency hedges by buying back euros.
The euro could perhaps gain in value, at least temporarily, in a scenario where investors discerned a diminution in political will to pursue fiscal policies and structural reform to complement the ECB’s monetary policies, particularly if there were also doubts on the ECB’s own commitment to further policy easing.
Certainly, on December 3, the ECB’s Governing Council chose to disappoint asset markets’ expectations for more radical monetary policy easing despite prior hints from Draghi and from ECB Chief Economist Peter Praet that had arguably raised hopes in the first place.
As for politics, Spain’s national election result of December 20 merely illustrated a trend that has been evident in a number of euro zone countries.
No single party won a clear mandate to govern Spain but the centre-left and centre-right parties were arguably the biggest losers as voters opted for new political groupings.
Populist parties, such as Spain’s left-wing Podemos grouping which came third in the Spanish poll, owe much of their support to an alternative approach which is incompatible with adherence to austerity policies which might be seen, in the wider euro zone, as the appropriate response to Spain’s economic problems.
In neighbouring Portugal, an inconclusive election result in October has finally seen the formation of a Socialist Party-led minority government backed by far-left parties who back an anti-austerity programme.
Meanwhile, in Finland three years of poor economic performance have eroded popular support for the euro and produced a coalition government that includes the euro-sceptic The Finns party.
The Finnish parliament will debate in 2016 whether or not to hold a referendum on membership of the euro.
“I think Finland should not have joined the euro,” said Timo Soini, Finland’s Foreign Minister and leader of The Finns party while admitting that any exit would be complicated.
Across the euro zone, the political centre has seen its share of the vote erode while investors can no longer be completely certain that the ECB is wholly committed to even more monetary policy easing.
As the ground shifts beneath their feet, investors may decide to unpick existing trades and, perhaps counter-intuitively, that may actually mean a stronger euro if only for a while.