It May Be A Weak Dollar Story, But Europe Is Center Stage In The Week Ahead

After trading in a $1.16-$1.20 range since mid-July, the euro broke out higher. The move to new two-year highs near $1.2075 came despite the deflation, the widespread recognition that the ECB will ease policy again on December 10, and the apparent economic divergence between the eurozone, which may be stagnating now if not worse, while the US economy appears to be posting solid, yet not spectacular, growth.

Back on September 1, when the dollar first poked above $1.20, there was a flurry of ECB comments, and the euro came off. Then, like now, we did not expect the break to be sustained. The ECB comments came as the market was, from a technical point, ripe for profit-taking. The technical indicators are stretched, which is not, of course, the same thing as turning lower. In July, the euro surged about 2.15% on a trade-weighted basis and then moved sideways until testing the $1.20 area on September 1. Since the end of October, the trade-weighted index has risen almost 2.20%. 

As prognosticators pull update 2021 forecasts, sentiment has swung hard against the dollar, though few match Stephen Roach's call for a 35% appreciation of the euro. The Bloomberg survey's median forecast for the end of 2021 has crept up to $1.23, and our $1.25 call for mid-2021 is looking too conservative.

The ECB does not want to be seen defending any particular level. Nor does the ECB want to signal that it is targeting the exchange rate. Given the importance of the dollar's exchange rate for EMU through trade and financial channels, of course, the ECB monitors it. And to say that exchange rates influence prices is to belabor the obvious. Deflationary forces would be less if the euro were weaker, perhaps, but surely it is not so linear. Many officials and economists also recognize, for example, that a weaker dollar is often associated with stronger world growth and rising trade.

Moreover, the current account surplus of more than 2% of GDP this year (2.3% in 2019) still reflects a competitive exchange rate. According to the OECD's Purchasing Power Parity model, the euro is more than 17% undervalued when trading near $1.21, giving it the dubious honor the being the weakest of the major currencies.

According to the OECD, the last time the euro was overvalued was in July 2014, when the euro traded in a two-cent range around $1.35. A recovery in world demand following the vaccination of massive numbers of people will bolster European net exports and widen the current account surplus next year.

To be sure, the exchange rate is not the chief economic challenge as the social restrictions are being extended throughout Europe. The eurozone could be experiencing an economic contraction here in Q4. Recall the economy contracted by 3.7% in Q1 and 11.8% in Q2 before rebounding by 12.6% in Q3. The composite PMI had been losing momentum since August and fell to 45.3 in November, which was sufficient to drag the three-month average back below the 50 boom/bust level (48.6).

Still, the outlook is brighter, and even with the downward revision, the OECD's new forecasts have the eurozone growing by 3.6% next year (down from 5.1%) and still faster than the US (3.2% revised from 4.0% ). 

The political challenges that Europe faces seem more formidable. A new trade agreement between the UK and EU remains elusive. Both sides hope the other blinks first. Neither side is blinking, but expectations for a deal over the weekend are elevated. Still, the UK is adding a new wrinkle to the plot. Recall that the government is in the process of passing the Internal Market Bill, which overrides parts of the Withdrawal Bill (divorce decree). The House of Lords diluted it with amendments that the House of Commons will reject on Monday.

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Read more by Marc on his site Marc to Market.

Disclaimer: Opinions expressed are solely of the author’s, based on current ...

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