Contrary to expectations, the euro has had a relatively stable year despite fresh easing measures by the European Central Bank (ECB). It wasn’t too long ago that the common currency looked like it was headed for parity against the US dollar. More than nine months into 2016, the EUR/USD continues to trade well above 1.10.
By mid-September, the EUR/USD exchange rate was trading in the mid-1.11 region, having gained 3.6% year-to-date. By comparison, the pair was trading around 1.05 last December.
However, the fourth quarter could present new challenges for the euro, as a moribund economy, geopolitical tensions and a stronger dollar take root.
Monetary Policy
Back in March, the European Central Bank expanded its already hefty stimulus program by delivering interest-rate cuts, bigger bond purchases and the possibility of subsidies to lenders. The 25-member Governing Council lowered the benchmark interest rate to zero and slashed the deposit rate to -0.4% from -0.3%. Central bank bond purchases were also raised to €80 billion per month from €60 billion.[1] The Bank remained steadfast in supporting economic growth and inflation by pledging to do more to raise output, If necessary.
As many would have expected, the impact of the Bank’s new stimulus efforts has been mixed. As a result, policymakers failed to announce changes to the program at the September Governing Council meeting. Contrary to expectations, the ECB didn’t extend the duration of its quantitative easing program beyond the current deadline of March 2017. However, the Bank did leave enough scope to expand the duration of its bond purchases, if necessary:
“Regarding non-standard monetary policy measures, the Governing Council confirms that the monthly asset purchases of €80 billion are intended to run until the end of March 2017, or beyond, if necessary, and in any case until it sees a sustained adjustment in the path of inflation consistent with its inflation aim,” the ECB said in its official statement.[2]
Economics
The Euro Zone economy got off to a strong start in the first quarter, growing 0.5%. The uptick was helped by a surprisingly robust performance from France, an economy that has seen its fair share of inconsistency over the past three years.
By the second quarter, growth had nearly halved to 0.3% – the slowest since mid-2015. Several countries saw their expansion slip in April-June, including regional powerhouse Germany. Italy, a country struggling with a deepening financial crisis, flat-lined in the second quarter.[3] That was the first time Italy’s economy failed to grow since 2014.
Euro zone inflation has shown nascent signs of recovery compared to the first quarter, but remains very weak overall and nowhere near the ECB’s target rate of just below 2%. Inflation was at or below zero throughout the first quarter.
Other Factors
Monetary policy overseas could play a major role in the euro’s outcomes in the fourth quarter. Investors will be on Fed-watch in the final three months of the year. According to Fed Fund futures prices, it’s pretty much a coin toss whether the US central bank raises rates before the end of 2016. A rate hike in December, as is currently being talked about, will likely lead the greenback higher against a basket of currencies, including the euro.
It also remains to be seen whether the Bank of Japan (BOJ) can finally put a stop to the yen’s strong gains this year. The EUR/JPY has declined more than 12% in 2016, despite continued efforts by the BOJ to stimulate the economy through quantitative easing and negative interest rates.
Italy’s referendum could also have major implications on the Eurozone economy. Italians will head to the polls in November to vote on reforming the constitution. Prime Minister Matteo Renzi is betting his political career on a “Yes” vote, which will allow his party to implement much-needed reforms.
Italian politics are heavily fragmented. The Five Star Movement, a populist right-wing party founded in 2009, is looking to take Italy out of the Eurozone.[4]
Speaking of regional exits, Britain shocked the world back in June by voting to quit the European Union (EU). According to recently appointed Secretary of State for Exiting the EU David Davis, Downing Street could formally notify Brussels of its intent to leave the bloc before the end of the year.[5] By triggering Article 51 of the Lisbon Treaty, Britain will likely send another jolt through the financial markets, including the euro.
[1] Alessandro Speciale and Jeff Black (March 10, 2016). “Draghi Expands ECB Stimulus With More QE and Lower Rates.” Bloomberg.
[2] Will Martin (September 8, 2016). “DRAGHI: It isn’t our fault banks aren’t making money.” UK Business Insider.
[3] Mehreen Khan (August 12, 2016). “Eurozone growth halves in the second quarter.” Financial Times.
[4] Sam Bourgi (September 3, 2016). “Economic Stagnation Adds to Italy’s Banking Crisis.” Economic Calendar.
[5] Laura Hughes (July 14, 2016). “New Brexit Minister David Davis declares Article 50 should be triggered by end of year.” The Telegraph.
