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Forex markets: The state of the euro, amid rates uncertainty and doubts about Greece

11 PENNE

– The dynamics in EUR/USD is mainly affected by two factors: (1) developments in respect of the “Greece” issue, and (2) monetary policy decisions by the ECB and Fed respectively. The first key event is the ECB meeting on 9 June..   


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            Up until some time ago it was thought that on this occasion the ECB would signal the next rate hike, expected in July (from 1.25% to 1.50%). But the complications surrounding Greece make the outcome of the meeting less predictable. Trichet might soften the rhetoric on the case for prompt action in the form of another increase in rates. This would likely be a signal that the search for a solution to the Greek crisis has made no progress and that the ECB is not confident it can afford another rate hike as early as July. If this is the rhetoric deployed by Trichet, the effect on EUR should be downward, potentially leading to a fall below 1.4000 EUR/USD.
            If, on the other hand, Trichet does not hesitate to use the “strong vigilance” tone, heralding another, imminent rate hike (July), this might mean that on the Greek front too an acceptable solution is not far off. Thus, EUR should strengthen, in which case the conditions might be set for an attempted upside breakthrough out of 1.4500 EUR/USD coupled with an acceleration towards 1.49-1.50 EUR/USD.

            – Irrespective of the tone adopted at the press conference, the talks on finding a solution for Greece will in any case have to continue, and the schedule is already set.
            The EU-IMF-ECB mission to Greece should be at an advanced stage: Euro area finance ministers head Jean-Claude Juncker said on Monday 30 May that he expect the mission report to be delivered in the coming days or early next week. He also said EU leaders would decide on a possible new package of aid for Greece by the end of June, adding that the option of a total restructuring of Greek debt had been ruled out. This news has already been helping the euro to
            appreciate from 1.42 to 1.44 EUR/USD in the past few days. The other two planned key events before which a solution to the Greek crisis must be found are the Ecofin meeting (20 June) and the European Council meeting (23-24 June).

            – Assuming that a solution will be found by the end of June, i.e. in roughly one month, and that it moves in the direction of granting another loan on very stringent terms, this should allay concerns over the peripherals and consequently it should also ease the downward pressures on EUR. At the same time, there would no longer be grounds for the concerns that Trichet may voice on 9 June over whether to lift rates or not. This would clear the way for a second hike in the refi rate, from 1.25% to 1.50%, at the ECB meeting on 7 July.
            The combination of (1) diminishing tensions over the peripherals, and (2) a fresh ECB rate hike would favour EUR. Thus, the 1-month horizon or slightly beyond is the window in which EUR should crystallise its strongest upside, potentially rising to 1.49-1.50 EUR/USD.
            This benign period might extend to some of the three-month time horizon, during which the conditions should ripen for a third rate hike by the ECB.

            – We have estimated that at the start of the ECB rate hike cycle the sensitivity of EUR/USD to 2Y EUR yields (proxy for rate hike expectations) is positive and stands at around 1.8%. Thus, a 25bps hike in ECB rates would be roughly equivalent to a gain of three figures, e.g. from 1.40 to 1.43 EUR/USD. The sensitivity is greatest at the start of the cycle and gradually diminishes as the hikes continue.

            – In addition to the dynamics in ECB rate hike expectations, EUR/USD also reacts to the dynamics in expectations regarding Fed rates. In this case the sensitivity is negative at around – 1.4%, corresponding to around a couple of figures less per 25bps hike in Fed Funds, e.g. from 1.40 to 1.38. In this case too the sensitivity is higher when market expectations of a rate hike start to materialise and/or at the start of the rate hike cycle, and even more so in the US case given that Fed Funds are close to zero (0-0.25%), whereas the ECB refi rate is much higher at 1.25%.

            – With the Fed set to terminate QE2 in June, the following months will form the prelude to the start of the rate hike cycle, which can be put at between year-end 2011 (final FOMC meeting of the year on 13 December 2011) and first quarter 2012. Thus, expectations of a rise in Fed Funds should start to form beyond the 3M horizon and before year-end, producing a downward effect on EUR. Accumulating a run of initial rate hikes, considering the sensitivity referred to above, the downside scope would penetrate below 1.40 to at least 1.35. An attempt within the range 1.35-1.30 EUR/USD cannot be ruled out – especially if the central scenario materialises of a slowdown in Euro area growth in 2H11 vs. stabilisation/consolidation in the United States.

            – The summer period and possibly the start of autumn, i.e. when US rate hike expectations would start forming, might represent the last significant chance of a final surge (rebound/possible new highs) in commodities in general (with due exceptions), notably oil and energy. The markets would see the start of US tightening as a sort of demonstration that US growth remains satisfactory even after the crisis and after the end of the expansionary policies. Since this year the markets have frequently seen global growth as China growth + US growth, given the high level of the former it is the latter that makes the difference and provides the acid test.

            – On the other hand, a slowdown in global growth, albeit modest, is expected in 2012, which should justify some cooling of commodity prices, though not necessarily a collapse.

            – In the expected global slowdown in 2012, the US economy is predicted to consolidate/accelerate slightly, vs. a visible slowdown in the Euro area. This is the underlying reason behind expectations of EUR weakening, or at least stabilisation at lower levels with lows around 1.30 or even slightly below, between 1.30 and 1.25. The peripherals issue, which will rear its head repeatedly next year too, is not just a downside factor for EUR but also acts as a curb on Euro area growth.



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