EUR/USD forecast change: The peripheral crisis is likely to deepen
The problems in the euro area have deteriorated significantly and are likely to worsen further before stabilising. Heightened risk, coupled with more dovish language coming from the ECB and the SNB floor, has made a lower EUR/USD likely in the short run. We are therefore lowering our EUR/USD forecasts significantly to 1.33 in 1m and 1.25 in 3m.
European problems are likely to get worse before they improve…
There are two main problems facing the euro area in the short run. First, most investors think that a restructuring of Greek debt is a matter of when and how, not if, but the “when” and “how” matter enormously and are very unclear. Second, there is increasing pressure coming on Spain and particularly Italy, and the market is unconvinced that the EFSF will prove enough to stabilise the situation. According to our recent Global Macro Survey: Pessimism about Europe grows, 18 September 2011, 62% of rates investors think that it will not succeed and of the 38% of the remaining optimists 28% think that it will only work if the ECB allows the EFSF to lever up using its balance sheet.
In both cases politicians across the euro area face an extraordinarily difficult job in convincing their electorates that strong action is in their interests and market participants that they are in control of the situation. They may need to use market sentiment deteriorating further to demonstrate the seriousness of the situation to their electorates in order to take the measures that eventually stabilise markets, which is much easier said than done. In short, we think that even if they are able to stabilise the problems the first step will be a further deterioration.
… leading to looser European monetary policy and a higher risk premium on the EUR
This matters for the value of the EUR in two ways. First, it is likely to lead to looser monetary conditions in the euro area. The relatively hawkish stance that the ECB has taken over the past year or so has been a crucial support for EUR/USD and to our generally bullish forecasts. But the likelihood of a rate cut has increased significantly. As a result, our economics team has changed its ECB call: it now expects rate cuts in October and December as well as a widening of the interest rate corridor. And even if the ECB does not change its policy rate, it has proved adept at affecting monetary conditions in other ways – allowing the EONIA rate to fall, providing unlimited term funding at a fixed rate, etc.
Second, the risk premium on EUR/USD is likely to fall. This has both a EUR and USD aspect to it. The EUR is likely to demand a higher risk premium because the problems in Europe are increasingly the most important risks facing global markets. In our survey, 60% of global equity investors thought that European banking fragility was the biggest threat facing prices; a quarter before the majority had thought that weak growth, centred on the US, was the big threat. The closer links between the euro problems and global wealth demand a higher expected return.
The USD has also become a more attractive hedge for euro area risks because of the EUR/CHF floor imposed by the SNB. It might not hold in the long run but in the short run the SNB is bound to defend it robustly, meaning that the CHF is a much less attractive hedge. FX is a zero sum game so some other currency must benefit, and we do not agree that it is an alternative European currency such as the GBP or NOK. Both are too cyclical and too vulnerable to European growth concerns. The USD looks far more attractive.
We do not expect a EUR collapse though
Many investors have been frustrated by the resilience of EUR/USD given all the problems. Despite the deterioration in prospects we should not forget the reasons why it has held up. First, European policy makers have generally done what was necessary to stabilise concerns in the short run. Second, the ECB has been assiduous in keeping the anti-inflationary faith. Third, this is primarily an internal problem, not one that the currency plays a big role in solving. Fourth, the USD has been very weak because of both monetary policy and the structural problems in the US. Despite the deteriorating prospects, none of these has changed completely, though all are likely to come under pressure, for the reasons above. We think this means that EUR weakness will be marked but not catastrophic. We do not think it at all likely that EUR/USD will fall significantly below 1.20 even if conditions deteriorate more than we expect.
BARCLAYS CAPITAL
FOREIGN EXCHANGE RESEARCH | INSTANT INSIGHTS