The most common question I get asked in my position as a currency strategist is; "why is the euro so strong?" Normally there are some rather more colourful turns of phrase included within that question, mainly as a result of the person losing money by betting against the single currency; a common occurrence in recent months. There are a fair few strong reasons why the euro has recently gained support and one reason why it should all come crashing lower.
Firstly, we don't really have any political issues on the radar in the near term for the Eurozone. Bouts of euro weakness have been characterised by political strife; governments in Greece falling, Berlusconi's ousting and subsequent re-emergence and Spanish corruption allegations have all played their part in the past few years. At the moment there is little to worry about politically.
Granted, we don't have a government in Germany as of yet and French political schisms could be one of the hot political topics of 2014 if growth isn't forthcoming. But, for now, the politicians who have done so much damage to the Eurozone are quiet.
Second is the ECB's relative monetary policy. Despite the European economy being the weakest of the G4 (US, UK, Japan and Eurozone) it has the tightest monetary policy. Rates in the US and Japan are effectively zero with large stimulus coming via quantitative easing plans, and in the UK, despite matching the ECB's 0.5% main rate, the Bank of England has engaged in QE, a 'funding for lending' scheme and forward guidance.
The ECB is legally unable to engage in monetary stimulus via asset purchases, hence the attraction of the euro on yield grounds. The European paranoia around inflation only adds further to an institutional lack of desire to further cut rates to stimulate growth.
Third is the Eurozone's current account. Funds have floated back into the Eurozone in recent weeks and months as investors become less and less worried about risks of sovereign default. With these surplus levels of funding, peripheral Eurozone countries no longer need to worry about financing from abroad to pay for government spending in the face of lower tax revenues. A strong current account and a strong currency go together like peaches and cream.
Lastly, there is the US dollar. Currency markets are always likened to the "ugly sisters" from Cinderella. Investors have to pick which sister is the less ugly and take her to the ball. At the moment, given the decision of the Federal Reserve to extend its asset purchase program past where most market commentators had thought, has seen the market sell the USD of late. The damage to the US economy that the governmental shutdown and fiscal fight has wrought has only magnified this. EURUSD is the most popular currency pair to trade in the world and therefore, if people are looking to express dollar weakness, EURUSD will rise, dragging a stronger euro with it.
And so the euro strengthens but at a price; the major risks to the Eurozone moving forward would be declining exports due to a simple lack of affordability and deflationary risks from limited import inflation - this is happening before our very eyes and has been confirmed by data in the past week. Inflation in October, shown to be negative month-on-month in Germany on Wednesday, slowed to a flat reading in the Eurozone, while the year-on-year number fell to 0.7%, the lowest since October 2009.
Further negative data came in the form of news that unemployment has hit a record high in the Eurozone. Joblessness now sits at 12.2%, and more importantly, the additional revisions to the past 3 months that had showed an encouraging improvement in the jobs market have now cancelled that good news out. The trend has been of worsening employment, and has been all the time.
This economy needs interest rate cuts, pure and simple. Whether we receive one at next week's meeting is still up for debate, however; I would not be surprised if the ECB still act in their typical, glacial manner and signal a rate cut at the November meeting, laying the groundwork for a cut in December.
Good news will come in a slackening of the single currency; some corporates and their country's Finance Ministers had already expressed reservations as to how strong it could become if left unchecked. More rate cuts are needed to bring the Eurozone back from the brink once again.