The Euro's Surprises May Just Be Getting Started
The euro is on the move, due to positive fundamental and technical reasons. And there is likely still more upside ahead -- potentially a lot more. The European Central Bank meets Thursday, and although this gathering may be ho-hum, with no real changes in policy, the realities of a strong economy will put pressure on the bank's president, Mario Draghi, to start mapping an exit strategy from ultra-accommodative measures before inflation becomes a problem.
In 2017, the shared currency had its best year against the dollar since 2003, rising from a low of about $1.04 in early January to finish at $1.20. Bearish parity forecasts were prevalent at the beginning of 2017, but fundamentally strong euro-zone economic data supported the euro throughout the year, which I predicted last January.
What made the euro rise in 2017 even more remarkable was that the Federal Reserve raised interest rates three times rates and U.S. equities as measured by the S&P 500 Index jumped 19.4 percent, while the ECB was going full-throttle on its quantitative easing program with negative deposit rates.
In purely economic fundamentals, Europe is exceptionally strong. IHS Markit's monthly survey of purchasing managers at manufacturing companies -- which has been an important leading indicator of growth since 1997, rose to a record 60.6 in December 2017. A measure of German business sentiment from the Ifo Institute has also been at record levels in recent months. The euro-zone economy is not just in recovery, but is approaching the velocity necessary to end QE.
Euro bears, which have become an endangered species in recent months, might be quick to note that the rate of inflation remains low, coming in at just 1.4 percent in December 2017. But low inflation didn't keep the Fed from raising rates in 2017, and the ECB is far more sensitive to inflation than the Fed. Remember when the ECB raised rates in 2008 in the middle of the last recession? At the first hint of inflation, the ECB will clamp down on monetary stimulus and quickly switch to playing whack-a-mole.
Foreign-exchange traders often talk of currency cycles in which the dollar is strong and then weak for seven-year periods. The most recent period of dollar strength began in early 2015 with the ECB announcement of its QE program. Whether you believe in the theory of seven-year cycles is moot, because the period of dollar strength may already be behind us, especially with the prospects of the U.S. issuing more debt to make up for revenue lost from tax reform.
The ECB will soon shift toward tighter monetary policy, and even though it shouldn’t be a surprise when it happens, it very well could be. This means that the euro's upside hasn't been fully realized, even with the Fed forecasting three more rate hikes this year. Although futures show that the Fed's possible actions are largely priced, the potential for ECB accommodation removal is likely not.
Short-term euro technicals are bullish, with moving average, volume and relative strength measures showing support for the currency. The longer-term bullish technical dynamics are even more pronounced. It is not difficult to imagine that the euro weakness of the past two years against the greenback, as can be seen in the long-term chart below, may turn out to be a short-term deviation from a higher natural exchange rate against the greenback.
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