2017 Euro Outlook

ECB policies will inevitably be a crucial factor for the Euro, especially as overall currency levels are determined to a large extent by changes in relative yields.

The overall stance will be particularly important given that the ECB faces tough decisions on how to manage any exit from non-conventional policies.

There will be a high degree of political uncertainty within the Euro-zone during the year which could have very important implications. Uncertainty will also be a crucial factor surrounding the new US Administration and a lack of cohesion would risk triggering a sustained increase in volatility.

Overall Euro ranges against the dollar have been relatively narrow during the past two years, but there are likely to be wider ranges over the next six months given the risk of sharp changes in both monetary and fiscal policy.

ECB remains a crucial focus

The central bank is currently buying EUR80bn per month in government bonds as well as purchasing corporate bonds.

The ECB has pledged to maintain this rate of bond purchases until March 2017 or beyond, if necessary, and in any case until it sees a sustained adjustment in the path of inflation consistent with its inflation aim.

The main refinance rate has been held at zero since March and the deposit rate is at -0.40% as the bank continues to punish funds held on deposit.

The Governing Council also expects that interest rates will remain at the present rate or lower for an extended period of time and well past the horizon of net asset purchases.

Reported inflation has edged higher over the past few months, primarily due to the impact of base effects as prices fell sharply late in 2015. The headline rate is likely to move significantly higher over the next few months with a potential move to above 1.0% as base effects continue, although there has been no significant evidence of an increase in underling inflationary pressures.

The immediate focus will be on December’s policy meeting as bank President Draghi has indicated that decisions on the future of bond purchases will be taken at that meeting.

The ECB will want to maintain policy support, but draw back from an extremely aggressive policy. The bank could decide to extend the full amount of bond purchases beyond March 2017, although there is also the potential for an announcement of a limited tapering in the amount.

There is an important risk of a growing rift within the Governing Council as headline inflation moves higher. The Bundesbank, in particular, will be very uneasy over maintaining a very aggressive monetary policy given fears of medium-term instability and higher inflation.

An increase in tensions within the ECB would make it much more difficult for President Draghi to maintain extraordinary policy measures.

Federal Reserve policy also very important

US Federal Reserve policy will also inevitably have a very important impact on the Euro trends.

There is a very strong probability that the Fed will increase interest rates at the December policy meeting with the Fed Funds rate rising 0.25% into a 0.50-0.75% range.

There is a high degree of uncertainty surrounding the 2017 outlook with a consensus expectation that there will be at least two further rate increases taking the Fed funds rate to 1.25% or higher. A significant increase in inflation or more expansionary fiscal policy could trigger a faster pace of rate increases.

All things being equal, Fed tightening will tend to put downward pressure on the Euro unless there is a sharp deterioration in the US growth outlook.

Euro-zone politics risks destabilisation

Euro-zone political concerns will inevitably be a key market focus over the next few weeks with extended uncertainties throughout the next few months.

The immediate focus will be on Italy’s referendum on political reform which will be held on December 4th. Reform is considered essential to help underpin longer-term structural reform and strengthen the overall outlook.

Defeat for the government would increase underlying concerns surrounding the Italian outlook and there is also the risk that Italian President Renzi could be forced to resign in the event of a defeat.

Government defeat would also increase wider concerns surrounding the Euro-zone political outlook.

The Italian referendum will also be a pre-cursor to important elections during 2017 with the, French Presidential vote concluding in May and a March general election in the Netherlands. The German Federal election will also be held in the Autumn.

There are further concerns surrounding an increased in support for populist parties and an underlying erosion of support for traditional parties of the centre-right and centre-left.

There will be concerns surrounding political fragmentation and increased support for populist parties which could destabilise confidence in the Euro forecast 2017.

Negotiations with the UK over the terms of an EU exit will also be a very important focus during the next few months. At the moment, the UK is looking to trigger Article 50 and start the formal process by March 2017, although this could be delayed. An antagonistic stance would tend to undermine wider Euro confidence as well as damaging Sterling.

Current account provides Euro support

The Euro-zone will continue to run a substantial current account surplus which is again likely to be at least 3.0% of GDP in 2016.

The surplus will tend to put structural upward pressure on the Euro, especially if there are no offsetting capital outflows from the Euro area.

The very accommodative ECB monetary policy has been very important in increasing net capital outflows from the Euro area with domestic investors substantially increasing their holdings of overseas assets while overseas investors have pulled out of Euro-zone bonds.

These outflows have been very important in weakening the basic balance of payments positons and have also been crucial in putting downward pressure on the Euro.

There will, however, be the risk of a sharp reversal in trends if there is any suggestion of an ECB policy change as residents could repatriate funds quickly.

Risk appetite trends important

Given the existing yield structure, the Euro is used as a global funding currency for carry trades into higher-yield instruments. When global risk appetite is strong, there tends to be an increase in flows out of the Euro which tends to weaken the currency. If, however, there is a sharp deterioration in risk conditions and a lack of confidence in the global economy, there is the risk of sharp short covering which will tend to support the Euro even if there are fears surrounding the Euro forecast 2017.

This feature leads to the paradoxical situation when ‘bad’ news for the Euro-one can strengthen the currency and the Euro forecast 2017 due to fears surrounding risk appetite.

ECB policies will gain be critical in this context with the potential for a sharp reversal in carry trades if the bank exits from the quantitative easing policies.

Trump Uncertainty a huge wildcard

The election of Trump to be US President has triggered a high degree of uncertainty surrounding the political and economic outlook on both sides of the Atlantic.

There will be speculation that there will be a more aggressive US fiscal policy which could increase pressure for a tighter Fed policy and also tend to weaken the Euro against the dollar.

There is also the potential for the US Administration to introduce a Homeland Investment Act which would encourage a flow of capital back to the US through the Homeland Investment Act and put significant downward pressure on the Euro. The US Administration could, however, push for a weak dollar and call The ECB an exchange rate manipulator.

Trade tensions and populist rhetoric could also unsettle the Euro, especially as it could also intensify underlying populist political pressures within the Euro area.

There would, however, also be the potential for an underlying deterioration in risk conditions which would offer some Euro protection with a reduction in carry trades. If trade tensions intensify, the Euro will also be insulated by a strong trade surplus.

Financial sector concerns ease slightly

The financial sector will continue to be an important focus with Deutsche Bank shares under heavy selling pressure this year due to solvency fears while there are very important vulnerabilities in the Italian banking sector.  There has, however, been a steepening in the yield curve which will help support the financial sector and concerns are liable to fade slightly over the next few months.

Market positioning liable to shift

Non-commercial positioning in the Euro has again been consistently negative this year and there has not been a net long position since early May 2014.  This positioning, although not as extreme as seen during 2015 will maintain the risk of a sharp adjustment in positioning and upward pressure on the Euro if there is a significant shift in underlying sentiment.

The draw of parity

The parity level in EUR/USD is extremely important for underlying sentiment and there is likely to be strong market pressure to reach this level if it comes within reach. There would, however, then be the risk of a sharp corrective retreat, especially as speculative positions would have been substantially over-stretched to reach the target.  On a valuation basis, the Euro would be substantially undervalued at parity with the German economy extremely competitive in global terms.

Risk factors

• The US Trump Administration could pursue an aggressive dollar devaluation policy to boost exports which would put upward pressure on the Euro.
• A severe downturn in the Chinese economy would trigger a severe deterioration in risk conditions which would also encourage Euro short covering.
• A severe increase in Euro-zone political tensions would risk an internal crisis of confidence and fresh talk of a split with a hard and soft Euro area.
• A collapse in Brexit talks would trigger very high volatility and potentially weaken the Euro slightly with very high volatility.

Summary

Overall yield trends will remain negative for the Euro in the short term and there will be sustained Euro-zone political concerns, especially with very important elections in Germany and France next year. The Euro is likely to remain generally vulnerable in the short term and markets will inevitably make an aggressive push for parity if this level appears to be within reach.

ECB exit strategies will, however be very important and there is the risk of a very substantial reversal during the course of 2017 as the ECB looks to pare back monetary stimulus. The Euro is also at extremely competitive levels against the dollar already while the current account will remain in surplus.

After potentially remaining vulnerable early in 2017, there is scope for a significant Euro recovery, especially with the risk of fresh doubts surrounding the dollar as the Trump Administration takes office.