The euro currency looks like it has reached a tipping point this week, with the bullish picture shifting dramatically because of a couple of economic releases. Coming into this week, sentiment was overwhelmingly bullish, reflecting Fed dovishness contrasted against a more conservative ECB, an uptick in European economic data, and strong capital inflows, as discussed in our earlier note entitled “European banks: Climbing a wall of worry.” This argument seems now to have been turned on its head.
The first pin fell on Oct. 30, when minutes from the latest FOMC meeting threw cold water on expectations that tapering asset purchases would come later rather than sooner. Language about signs of “underlying strength” in the economy have now reversed those expectations, with many participants now anticipating the first reduction will come in January instead of March 2014.
The second pin fell on Oct. 31, when European economic data took a turn for the worst. Of primary importance was a surprise cooling of euro-area inflation, to the lowest level in four years (Chart 1). This marked the ninth straight month that inflation has lagged the ECB’s stated target of 2%, and inflation now sits at a level last seen when Europe was mired in a deep recession.
The second data point was unemployment, which hit an all-time high of 12.2% for the euro area (Chart 2). Both releases contradict the prevailing positive sentiment that the region was growing stronger, and expectations have since emerged that the ECB will loosen its benchmark refinancing rate to 25bps from 50bps at its meeting in December.
Of developed-nation currencies, the euro has been the star performer so far in 2013 (Chart 3). The strong currency poses a risk to export-oriented Germany, by far the strongest pillar of support for the Eurozone, and has also contributed to lagging inflation as imports get cheaper.
Barring a significant weakening of U.S. economic data, or strengthening of European data, the winds have now shifted in favor of euro currency weakness. Establish new short positions here, risking the recent highs with a stop at 1.3850 (basis December futures).