The euro’s feisty rally has further to run
The currency, and the euro zone’s economy more broadly, have been the success story in global markets in 2017, leaving the dollar bulls with egg on their faces
On Christmas Day, Europe’s single currency lost 3 per cent against the US dollar in a matter of minutes in a drop that was attributed to so-called “algo trading” – automated trades which have led to a number of inexplicable sudden and sharp declines in currencies known as “flash crashes”.
The euro quickly rebounded and, in a sign of the extent to which international investors remain bullish on the world’s second-most traded currency, analysts dismissed the slide as a computer-driven glitch in holiday trading.
That even a flash crash failed to ruffle the feathers of euro investors says much about the optimism surrounding Europe’s single currency since the victory of the pro-European Emmanuel Macron in France’s high-stakes presidential election last May.
The euro, and the euro zone’s economy more broadly, have been the success story in global markets in 2017.
Since mid-April, the euro has surged more than 12 per cent against the dollar and has been the best-performing currency in the G10 group of advanced economies this year.
Everything has gone the euro’s way in 2017, including the plunge in the dollar, with the dollar index (a gauge of the greenback’s performance against a basket of other currencies) down 9 per cent this year to its lowest level in nearly three years.
Yet the real momentum behind Europe’s single currency is within the bloc itself.
The euro zone’s economy and financial markets have been firing on all cylinders. The latest Purchasing Managers’ Index survey, published by IHS Markit on December 14, showed the bloc’s manufacturing sector expanding at its fastest pace since 2000 and the services industry growing at its briskest rate since 2011.
Job creation in the euro zone has risen to its strongest level in more than 17 years. Most encouragingly, Europe’s recovery is broad-based, with France (until recently Europe’s economic laggard along with Italy) outpacing growth in Germany, the region’s economic powerhouse, for the third month running, according to the survey.
It is in the markets, however, where the effects of the euro zone recovery have been most apparent. After sliding 27 per cent between April 2015 and June 2016, euro zone stocks have since shot up 30 per cent. Inflows into European equity funds have surged since Macron’s victory, buoying the euro, while yields on euro zone government and corporate bonds have been driven down by the European Central Bank’s aggressive asset purchase programme.
Portugal, which is still rated “junk” by two of the three main credit rating agencies, has seen its 10-year yields plummet nearly 200 basis points this year to a mere 1.7 per cent.
The big question is whether this is as good as it gets for the euro? The answer is almost certainly not.
The euro is benefiting from a number of tailwinds which will persist, or become even stronger, in 2018. The most important is the European Central Bank’s plans to scale back, or taper, its bond-buying programme once the scheme runs its course in September.
Even though inflation in the euro zone is likely to remain subdued, it should rise sufficiently for the ECB to call time on quantitative easing.
Speculation about the timing of the end of European QE, and when exactly interest rates will start to rise, will intensify next year, maintaining upward pressure on the euro.
Europe’s economic upturn is also likely to persist, underpinned by a much-improved labour market which is supporting a strong recovery in domestic demand.
Even Italy, which is struggling to recover from a bruising recession, is enjoying stronger growth, helping allay market concerns about the outcome of the country’s parliamentary election in March in which populist parties are expected to perform well.
Another reason the euro’s rally is unlikely to have run its course is that the woes of the US dollar show no signs of abating – indeed quite the opposite.
In one of the most striking developments in markets in 2017, the greenback has failed to benefit from the increase in the spread, or gap, between 2-year US and German bond yields to its widest level since 1997. Three interest rate rises by the Federal Reserve this year – and the prospect of three more in 2018 - have done nothing for the dollar.
Still, even the most compelling currency trades can go spectacularly wrong.
At the beginning of this year, investors were convinced the dollar would appreciate sharply because of Donald Trump’s pledge to aggressively stimulate the US economy. A year on, the dollar bulls have egg on their faces.
Yet with the dollar still deemed to be overvalued, the euro’s rally almost certainly has further to run.
Nicholas Spiro is a partner at Lauressa Advisory