A green light to buy the Euro

Nadya Mihaylova - 17 May 2017

Bullish sentiment is rising in the Euro area following signs of increasingly solid economic recovery and diminishing presence of geopolitical risks. The outcome of the recent French election and a stronger sense of confidence among investors have put to flight forecasts of the Euro reaching parity versus the U.S. Dollar. Escaping from the economic woes and negativism which had antagonised the eurozone for a long time will help the single currency to perform well in the medium to long-term.  

It is finally time for analysts to adjust their expectations: the political risks which were holding the Euro down have dissipated, at least for now. Emmanuel Macron has promised to reform the labour market and cut corporation tax to make businesses more competitive on the international stage. The legislative election in June will determine his ability to deliver on his mandate, but the most recent polls have suggested that Macron’s new movement “En Marche!” is likely to form a majority in parliament. This will strengthen his position and give him a better chance of implementing his pro-business policies quickly. Italy poses the biggest risk for the Euro in the long-run, however. The country is expected to hold its next general election no later than 2018 and the most popular party – Five Star Movement – has promised to hold a referendum on Euro membership. While the political risk in Europe has not completely faded, this is a more distant threat which is unlikely to weight on the down-side in the medium term.

According to data from EPFR Global, weekly capital inflows into European stock funds reached a record of $6bn post the French election, adding to the strong momentum in Euro appreciation (fig 1). This comes on the back of accelerating output in line with analysts’ expectations and very strong manufacturing figures growing at a faster pace than in the US (fig 2). Strong business earnings and tightening labour markets have also contributed to the growing appetite for European assets. As the valuation of U.S. Dollar and equity markets seem overstretched, investors have found more appealing alternatives in Europe in their efforts to secure higher future returns. 

While the ECB is unlikely to tighten its monetary stance appreciably before the end of 2017, early announcements or hints of a policy tightening – such as Peter Praet’s comments this week – will be priced in the currency markets immediately. If the economy continues to revive, the Euro has plenty of scope to appreciate further as bond yields begin to rebound on the back of higher interest rates and QE tapering. The inflation rate in the Eurozone is already close to the target, and recent indications that oil prices will remain supported by OPEC and Russia give further cause for the ECB to tighten its stance sooner rather than later. On the other side of the Atlantic, the Federal Reserve could potentially shift the timing of any further interest rate hikes further out due to the disappointing data on inflation and retail sales. These developments are already contributing to the weakening of the Dollar against the Euro (fig 3). Speculative positioning has moved in favour of the Euro for the first time since March 2014. The Euro should gain further ground as president as Trump struggles to push his policy agenda through Congress.

Figure 1

Figure 2

Data Source: Thomson Reuters Datastream

Figure 3

Data Source: Thomson Reuters Datastream

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