This Could Crush the Euro in 2016
The European Central Bank’s (ECB) Mario Draghi is no longer dovish in his tone. He has all but confirmed that a rate cut is in the cards, which could depress the EUR to USD exchange rate. Three defining factors are at play here, which bear a negative outlook for the euro to dollar exchange rate in 2016.
Take note that three economic and financial headwinds in the eurozone have triggered the ECB’s desire to cut rates. All these have almost made it inevitable for Draghi to go for monetary stimulus.
Recession Is Here!
The eurozone is struggling with a critical situation of deflation. Inflation currently stands at an unbelievable low of only 0.2%. Low commodity prices are further aggravating this deflationary pressure. (Source: “Mario Draghi defends ECB’s monetary easing policy,” Financial Times, January 25, 2016.)
Now, we all consider inflation to be the mother of all economic evils. This is because of the negative economic connotations it holds. But little is ever said about its evil twin—deflation. Like high inflation, low inflation is also detrimental to the economy’s health. Inflation levels hovering over zero mean low consumer demand. This translates into low economic output and higher unemployment.
In times like these, Draghi has only a limited number of options at his disposal. By limited, I mean one—that is, to cut rates to give some inflationary boost to the economy.
The European markets were firing on all cylinders earlier last year. But come this year, they are now losing their fuel. It is not altogether wrong to say that the winning streak is over for the European stocks. Sure, some of it may have had to do with the Chinese market crash at the beginning of this year. But most of it has to do with the eurozone’s own problems.
The fact of the matter is that the region’s corporate sector is struggling with an economic slowdown. Cuts in earnings guidance have made the future outlook bleaker. In fact, global earnings revisions now mirror the ones seen back in the Great Recession era of 2009. (Source: “Europe Stocks Enter Bear Market Only 9 Months After Record High,” Bloomberg, January 15, 2016.)
With the European markets now on their deathbed, only a stimulus can bring them back to life. There goes the second factor calling for a rate cut.
At the same time, bond yield spreads between corporate bonds and government bonds are widening. The disparity now stands close to the levels seen three years ago. Recall that back then, this region was struggling with the worst phase of its sovereign debt crisis. The similarity is uncanny. (Source: “A Hint of Trouble in European Debt,” The Wall Street Journal, January 18, 2016.)
Rising yields mean one thing: European corporations will struggle to pay back their debt. The reason being that industrial activity is slowing and so are their profits.
In other words, companies will find it costly to raise capital from the bond markets. But a rate cut will help, won’t it? With this, we come full circle with our reasoning for Draghi’s push for a rate cut.
Needless to say, the most obvious outcome of this move will be a decline in the EUR to USD exchange rate. The U.S. Federal Reserve may have done the world a favor by not raising rates this month. Another rate hike could have put further downward pressure on peer currencies.
But here’s the real scary part…
Fed Chair Janet Yellen has not completely ruled out the likelihood of a future hike later this year. If the Fed raises rates again while the ECB is loosening its policy, expect the euro to dollar exchange rate to plummet.