There is less downside risk to the euro-zone economy than the U.S. economy.
Nobody expects the European Central Bank to raise interest rates when policy makers meet Thursday. Even so, conditions are ripe for the euro to resume its upward trend after stalling for much of the past three months.
The naysayers like to point to purchasing manager index, or PMI, surveys showing a deceleration in manufacturing and the potential for growth to slow as the reason why the euro hasn’t been able to follow through on its big gains from last year. But the truth is, there is less downside risk to the euro zone economy than there is in the U.S. economy. The euro zone has enjoyed low inflation of only 1.3 percent, despite showing relatively strong year-over-year GDP growth of 2.7 percent. And although PMI surveys have weakened in recent months, they are still at high levels following a massive 57-month-long expansion through March.
In contrast, there are significant downside risks to the U.S. ISM Manufacturing Index for April following the massive drop in the Empire Manufacturing Index’s expectations series. That series saw the second biggest one-month decline in its history, bigger than any one-month drop during the financial crisis or when equity markets were pummeled during the Great Recession.
Although the dollar became one of the few uncorrelated assets when inflationary risks triggered cross-market selloffs in February, the greenback has struggled to rise above critical technicals. Even as equities declined on Tuesday, the dollar also came under pressure. And there could be more downside for America’s currency even if the Federal Reserve accelerates the pace of interest-rate increases and the ECB presses ahead with loose monetary policy.
The dollar could come under pressure from the rising U.S. national debt as budgets get “porked up.” There are also risks of an economic deceleration, with the economy and labor market operating almost beyond peak capacity. Also, equity markets are no longer bolstered by the massive optimism that accompanied a once-in-a generation re-valuation trade in 2017.
The Fed watched the ECB almost torch its economy when it reduced its balance sheet rapidly from July 2012 to September 2014. Now, the ECB is in the catbird seat, watching the impact of the Fed’s moves. The ECB’s best course of policy is to let the Fed wade further into the morass of balance sheet reductions and monetary tightening, because the quagmire may be deeper than it seems. Any short-term dollar bump could turn into a slump if U.S. growth slows too much on higher rates.
This approach need not be bearish for the euro in the short term, either. After all, the euro rose from a low of $1.04 at the start of 2017 to around $1.20 by the end of the year, even though the Fed was raising rates and starting to reduce its balance-sheet assets. Looking at the long-term trading trend of the euro and the dollar, the dollar’s strength is the exception, not the rule. The euro looks more likely to move toward the mid-$1.30s from a recent $1.22, while the greenback, as measured by the Dollar Index, is more likely to fall back into the mid-80s from around 91.103 currently.
And even though the ECB is likely to keep rates unchanged, the euro is unlikely to break below a critical floor at $1.16. The ECB may be content to sit back and let the Fed forge the painful way forward to monetary austerity.
© 2018 Jason Schenker All rights reserved.