Euro Stimulus Withdrawal Rally Vulnerable to Risk Trends, ECB

Fundamental Forecast for the Euro: Neutral

• Spain suffers deeper recession in 4Q as banks repay LTRO funds

• Euro-area inflation cools as unemployment holds near record highs

• Retail traders continue to try and pick a top to EURUSD despite drive higher

Despite a conspicuous string of disconcerting headlines and economic releases, the euro put in for the best performance amongst the FX benchmarks this past week. While both the 15-month high for EURGBP and nearly three-year high for EURJPY are remarkable, it is still the EURUSD that stands out in the market. The 1.3 percent climb for this most liquid pair easily cleared the 1.3500 level that stood as the mid-point of the 2011 (high) to 2012 (low) range. After six consecutive months of rally, when will this pair show some exhaustion? That is a determination for fundamentals.

There is a reason that the Euro has been able to ignore pressing issues like expectations of a 2013 recession for the regional economy, lingering fiscal risks in Spain (amongst others) and troubled liquidity health. All of those issues have become almost normal in the past three years as the markets have reacted to crisis and then to policy officials’ efforts to forestall crisis. What is novel – especially given the escalation of the so-called ‘currency war’ – is the European Central Bank’s (ECB) unusual reduction of its balance sheet.

Increasing stimulus means injecting more currency into the money system and lowering market rates. Though this supports growth and lending, it also diminishes a currency’s return potential. And, on that point, we know that the Federal Reserve is adding $85 billion per month in stimulus while the Bank of Japan has vowed 13-trillion-yen (roughly €100 billion) moves come the beginning of 2014. In contrast, the ECB has maintained only a threat of buying a potentially unlimited amount of government debt through the Outright Monetary Transactions (OMT) program should vague conditions be met.

That relative position alone may have kept EURUSD and other euro crosses steady, but we have seen the shared currency surge because that steady policy has turned into a tightening one after the Long-Term Refinancing Operation (LTRO) early repayment threshold was met. Last week, European banks paid back more than €137 billion of the more than €1 trillion they took in liquidity assistance starting in December 2011. Such a big reduction runs the risk of putting the European banking system into a dangerous position should global investor confidence fade, but the €3.5 billion pledged repayment in the coming week speaks to a more restrained pace that helps avoid disaster.