16 December 2015

What is in a name? 20 years of the Euro

By Enrique Díaz-Álvarez

December 16 marks the 20th anniversary of the official birth of the Euro – a decision taken at the European Council meeting in Madrid on this day, two decades ago. From the minutes of that meeting, we clearly understand the rationale behind the name: that the name should be “simple and symbolize Europe” while also being “the same in all the official languages ​​of the European Union, taking into account the existence of different alphabets”.

From this date it took a little over three years for the Euro to be introduced in non-physical form at midnight on 1 January 1999. Two years later the physical currency was used for the first time – records suggest it was to purchase 1 kilogram of lychee fruit. This was the start of 17 years of financial activity which saw plenty of volatility against its major peers.

The Euro plunged to lows during its first three years of existence. Around 2002 it begun a multi-year rally against the dollar that peaked in 2008. This Euro rally was driven predominantly by two factors:

1. An improvement in Eurozone economic conditions, although, as it turned out later, much of this improvement was due to unsustainable asset inflation and debt build up in the periphery

2. The start of a Federal Reserve easing cycle in late 2007, while the ECB (wrongly, as it turned out) maintained a hawkish stance

The Euro’s appreciation was cut short by first the onset of the financial crisis ion 2009, and then the onset of the debt crisis in the periphery in 2010-11 triggered a drawn-out depreciation over the next few years that has brought the common currency back to near parity with the dollar.

In order to support the Eurozone’s ailing economy, the European Central Bank reduced interest rates to a record low 0.05% in November 2011 and launched its large-scale QE program in March 2015. However, the critical intervention came in mid-2012, when President Draghi stated the institution will to do “whatever it takes” to preserve the currency union. This put an end, at least for the medium term, to speculation about a breakup of the currency brought about by the massive economic and financial crises in peripheral countries.

Since 2011 the Euro has weakened and now approaches parity with the Dollar – having traded as low as 1.06 to the US Dollar earlier this month.

So with 2016 fast approaching, what is in store for the Euro?

We predict gradual Sterling appreciation.

The Bank of England was more dovish than perhaps anticipated by the markets at the November and December monetary policy meetings.

Why? Downside risks from abroad and the UK’s international competitiveness. Given that the Eurozone accounts for over 40% of total UK exports, Sterling strength is a headwind for the UK economy, and also makes it more difficult to bring inflation back to its target through cheapened imports. Therefore, we don’t expect interest rates in the UK to increase until well into 2016, likely in the third quarter of the year.

We believe that the Pound will continue its recent trend in the first months of 2016, travelling a middle path: up against the Euro and down versus the US Dollar while the BoE pursues a neutral path, the Fed tightens and the ECB eases. Hence, we forecast Sterling to appreciate gradually against the Euro as well as most other G10 currencies, most of whose central banks remain in easing mode.

We forecast the Euro to reach £0.71 by the end of the year and £0.67 by the third quarter of 2016.

In terms of the US Dollar, we believe that parity is on the horizon.

Despite the recent Euro rally over the past few days, the evident and growing divergence in the monetary policies adopted by the ECB and the Federal Reserve will likely result in a medium term appreciation of the US Dollar against the Euro.

The stark contrast in ECB and Fed policies was highlighted most recently by the ECB’s December announcement. Although the expansion in the QE program failed to match the markets somewhat feverish expectations, the statement highlighted that the ECB is far from finished pumping monetary stimulus, while the Fed looks on course to hike US interest rates at its meeting today.

We therefore expect EUR/USD to end the year at around the 1.05 level, before reaching parity at some point in the second quarter of 2016.

However, we think the pace of future rate increases is likely to be gradual – more so than perhaps was initially anticipated.

This is likely a direct result of the China-led global economic slowdown, which has dampened confidence and weighed on growth worldwide.

Enrique Díaz-Álvarez is the Chief Risk Officer at Ebury (www.ebury.com).