Mixed fortunes for the buck to help the euro

Kathleen Brooks
ANOTHER week, another lurch lower for the euro. This time it was fears about the finances of Hungary, not even a fully fledged member of the Eurozone, that caused investors to flee the single currency. And the arguments continue to mount about whether the euro ca survive.

Just this week the Royal Bank of Canada (RBC) and Merrill Lynch Wealth Management were the latest financial organisations that forecast further weakness for the single currency. RBC now expects it to fall to $1.18 by the end of the September, and to fall even further to $1.10 within one year, while Merrill Lynch Wealth Management expects it to drop to $1.15 and $1.10 by the end of this year and next.

Although uncomfortable for investors sitting on piles of euros, they might have found RBC’s justification for downgrading their forecast positively chilling. “The impact of the euro’s diminishing status as a reserve currency may have only just begun to play out,” RBC analysts wrote in a note to investors on Monday. Likewise, currency strategists at Bank of America Merrill Lynch argue that “fragmented policy responses across the Eurozone, selling by foreign exchange reserve managers, and risks around the Eurozone banking sector are expected to drive the euro down [further]”. Right now it’s hard for investors to construct a scenario where the euro can appreciate.

But in amongst this horror story for the single currency, there are a few in the market willing to show some vocal support for the euro. Deutsche Bank argues that although short-term pressures will likely push the currency down to $1.15, after July sovereign debt redemptions in Spain will ease significantly and, combined with the European Central Bank’s bond purchases, pressure on the euro should start to decrease. It argues that with the market massively short euros, such a one-sided view of the currency should make one stop and pause. It also adds that the market has unfairly shrugged off the policy response devised by Eurozone members and announced on 10 May, even though it significantly reduces the probability of a default in the next three years.

It even goes as far as to say that the crisis has led to greater integration within the Eurozone, since it introduces a mechanism to share fiscal risk. Investors should give the plan a chance, Deutsche analysts note, since when the US government announced a scheme to protect its banking system in 2008 and purchased billions of mortgage-backed securities, it took several months for the US markets to stabilise.

Deutsche Bank argues that once the ECB’s bond purchasing scheme takes place that should reduce pressure on the single currency since it would cut significantly the risk premia of a member default within the Eurozone. But the real key to a change in fortune is the US dollar. “What helps the euro more fundamentally is that the US’s fiscal balance is not that much better than Spain’s and worse than the Euro area’s,” the analysts wrote. It also argues that the longer-term outlook for the US’s fiscal health is worse than it is for Europe. For example, its analysts calculate that the US’s debt-to-GDP ratio will balloon to 240 per cent by 2040, compared to 160 per cent for Europe, and the markets should start to focus on this: “So just as markets have moved from Greece to Spain and now to Italy, they would likely move on to re-price the US fiscal risk premia.”

The Eurozone is not in a healthy state, but for those with a cup half full mentality there is a chink of light at the end of a very dark tunnel.