Euro faces ECB headwindThe European Central Bank (ECB) looks in a tight spot. Whilst it has ended QE, the outlook for the Eurozone economy is very mixed. The goldilocks conditions of late 2017 are a distant memory and it does rather look like the ECB has been too slow to raise expectations. Credit conditions may well be tightened at precisely the wrong moment. Investor confidence has sunk to four-year lows, inflation expectations remains anchored at a level below the ECB’s target and growth is showing signs of cooling. Meanwhile the threat of a trade war is weighing heavily on export-focused Germany. Finally, political risks are mounting with Italian government still in dispute with the European Commission over its budget, while the yellow vest movement in France highlights how populism is rising in Europe. For the euro, we consider the growth levels but above all the ECB’s monetary policy, particularly interest rates. Markets have been banking on the central bank to start to raise rates in the back end of 2019, but those expectations may need to change. Increasingly uncertainty about when rates might rise will likely weigh on the euro. Meanwhile there is a risk that a global slowdown in 2019 results in the ECB needing to open the taps on QE again. Whilst remaining doggedly optimistic throughout 2018, by December even Draghi had to admit that risks were starting to tilt to the downside. The Eurozone’s exposure to global export markets is important as trade tensions become tougher and slowing growth in China will affect the bloc more than the much more domestically-oriented US economy. EURUSD risks heading back to multi-year lows at 1.03 if the ECB does have to restart QE.
Brexit tightrope for sterlingEconomic fundamentals and interest rates matter less for the pound than any other major currency because of Brexit. How and even if the UK leaves the EU is critical to the direction of the pound over the next few months. The range of outcomes makes it very hard to take a long-term position on the pound. A no deal exit could bring GBP/USD down to 1985 levels around $1.05 again. If there is a second referendum and Brexit cancelled, then a return to $1.45 looks likely. Amid that massive range there is any number of potential outcomes and levels for the pound.
In that regard, the current range for sterling around the $1.26 level suggests that sterling is significantly mis-priced – but only if we get one of the extreme outcomes. The two polar extremes – no exit and no deal – seem more likely now, but you just never know what will happen.