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Euro might depreciate a bit more
Author: Henk Luijten
Henk Luijten joined ING Investment Management (ING IM) in July 2000. As one of the financial editors of Investment Content Management (division of Marketing & Communications), he is responsible for the written communication of ING IM’s investment views and expertise to client servicing departments, ING Private Banking and to various client groups directly. He does so by writing a wide range of publications. Prior to joining ING IM, Henk worked as an editor and an investment analyst for MeesPierson and as a credit analyst for ABN Amro. Henk holds a Master degree (Law, Amsterdam, 1980) and a Bachelor degree (economics, Hogeschool Limburg, 1972).
On 13 January S&P downgraded a number of countries such as France and Austria (from AAA to AA+). In December the downgraded were already announced. For 2012 the outlook for currency markets continues to be uncertain.
The downgrades on 13 January by S&P do not change our outlook for currencies.
Main drivers of currency movements will be the same as last year: the euro sovereign crisis and the global economic cycle. In 2011, especially G10 commodity currencies (Australian dollar) and emerging market currencies were vulnerable for the risk-off and risk-on mood swings of global investors. In 2012, these currencies might do better. A cautious stance is warranted, however.
Rate spreads explain EUR/USD developments in 2011
Source: Thomson Datastream, ING IM (03/01/2011 to 03/01/2012
In 2011 the euro was strong and then weak
In spite if the euro sovereign crisis, the euro rose versus the USD in the first half of last year (from 1.34 to 1.45). In the last six moths of 2011 the euro lost ground. It ended the year at 1.30. Recently the euro depreciated a bit more (to 1.27). Although we think the euro is currently a bit oversold, we expect this trend to continue in the first quarter of 2012 (to a level of approximately 1.25).
A EUR/USD en igma
Many investors wonder why the euro was so strong in the first half of 2011. In view of the Eurozone peripheral debt issues some of them felt that EUR/USD should have traded lower. In our view, however, an important transmission mechanism from government debt to a weaker currency is via monetary financing /massive quantitative easing (QE). The Federal Reserve is already practising quantitative easing for some time, while the ECB has been reluctant until now to go this way. In the first half of 2011 the ECB even did the opposite, by hiking rates twice.
As the chart shows, rate spreads explained EUR/USD well in 2011.
Policy change by the ECB
In November and then again in December the official interest rate was cut by the ECB by 25 basis points (to 1%). We expect further rate cuts in 2012 (to 0.50%). In our opinion this policy change and the market expectation for more cuts were the most important reasons for the weaker euro in the second half of 2011/start of 2012. Of course, the ongoing uncertainties around the Eurozone do not support the euro. Therefore we expect the euro will stay weak in 2012. This could change if the Eurozone policymakers come up with a game changing solution to the crisis. At the moment it appears to be the policy makers’ intention to manage the sovereign crisis by taking small steps. Unlike equity markets, the euro did not get support from this gradual approach until now. One reason probably is that the US economy surprised on the upside, while the Eurozone economy at most stabilised at a low level.
US economy surprised on the upside
For the US the growth performance is expected to be a bit better than last year. There are two reasons for this. First, US households will receive a substantial boost to real disposable income growth from the decline in headline inflation and the lower unemployment rate. At 8.5% the unemployment rate is nearly a full percentage point below the level seen last year. Also, a substantial downside risk to real disposable income growth has been diminished now that the payroll tax cut and the emergency unemployment benefits are likely to be extended for the whole year rather than just until February. This should benefit non-durable goods and services spending, which has been particularly weak last year.
Eurozone and emerging Europe
In the current environment one of the stronger convictions we have is that the Eurozone economy will be weak in 2012. As already said, we therefore expect that the ECB will have to ease monetary policy further. This implies a lower euro versus the US dollar. It also suggests further weakness of currencies that are vulnerable to the Eurozone sovereign crisis. Apart from Eastern European currencies, one can think of the Swedish Crown, given Sweden’s high export ratio to the Eurozone and even the Swiss Franc as the Swiss economy is slowing down rapidly, the currency is still overvalued and the 1.20 floor seems credible.
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Relevant links
Senior Investment Specialist Ad van Tiggelen about Asset Allocation in October.