How strong is the US dollar? Euro 2023 outlook increasingly bullish amid global recession
The European Central Bank (ECB) predicts a positive outlook for the euro in 2023. However, markets need to recognize the progress made since June as the continent works to mitigate the effects of the Ukraine war and supply disruptions.
It was a significant accomplishment to reach an immediate agreement on the importance of fiscal deployment in the face of rising energy prices to stabilize household and industrial cashflows.
At least for the rest of this year, there are enough resources to prevent any significant slowdowns in activity. The sharp decline in euro holdings was quickly reversed, and the June warning of a 1.9 percent drop in euro area GDP in 2023 faded into history.
ECB’s euro forecasts
A 0.5 percent increase in GDP is predicted for the Euro Area in 2023, with a subsequent 1.9 percent increase in GDP the following year, per the most recent forecasts from the ECB.
In the medium term, the euro will remain to perform better than expected, and the ECB can keep its current approach without feeling pressure from its counterparts.
There is a more even distribution of the tightening financial conditions through rate increases because there is no issue with household leverage in the Eurozone, which has led to significant shifts in the policy forecast for the U.K. and Scandinavia.
Second, as loans from targeted long-term refinancing operations are repaid, there is considerable room to reduce certain aspects of the balance sheet. If all TLTRO-II loans were repaid, the ECB’s balance sheet would be reduced by 24 percent.
Third, despite initial doubts about credit spreads and the first plans for the transmission protection instrument, counter-cyclical fiscal support gives the ECB more leeway in implementing monetary policy. Throughout the third and fourth quarters, the market was much less optimistic about the U.K.’s fiscal prospects than the Eurozone’s.
Even though the outlook for 2023 will remain extremely sensitive to new data and unexpected events, the ECB’s policy differentials story extends far beyond the zero lower bound.
However, the beginning of balance sheet contraction through maturities has also affected financial conditions. The Fed Funds rate has had the most significant impact on sentiment. Most of the effect on sentiment has come from the Fed Funds rate’s volatility, but the start of balance sheet contraction through maturities has also affected the market.
In surplus economies like the Eurozone and Japan, where quantitative policies were initially implemented to fill an investment gap, the impact of balance sheet contraction is amplified, whether or not the monetary policy is the initial transmission mechanism.
What experts say
As explained by Standard Chartered’s head of global G-10 FX research, Steve Englander, the euro is trading within the range it has occupied since late December. However, the new information since the start of 2023 suggests that it should be more robust.
Englander maintained that as core inflation and economic surprises in the Eurozone have strengthened further, the ECB has found it easier to maintain its hawkish stance.
He added that concerns about the state of the energy market, which had been a significant drag on the EUR as of mid-2022, are dissipating.
Core inflation increased more than expected, reaching a high of 5.1 percent when the effects of fluctuating energy, food, alcohol and tobacco prices were excluded.
The ECB and the U.S. Federal Reserve have recently adopted a more hawkish stance to bring inflation back within their respective targets.
At a conference, ECB policymaker Robert Holzmann said that interest rates must rise significantly further to reach sufficiently restrictive levels to ensure a timely return of inflation to the ECB’s two percent medium-term target.
Englander noted that data surprises in the U.S. have been weaker than in Europe, which indicates that rates aren’t being pushed up as much.
He also said that the average hourly earnings (AHE) trend in the most recent report was much less alarming than the data the Federal Open Market Committee (FOMC) was running on in mid-December when the annualized growth rate of earnings for the previous six months through November was 5.3 percent and soaring.
Englander highlighted that in the most recent report that the annualized wage increase for the 6M dropped to 4.4 percent in December. Aside from the devastating impact of COVID in 2020, the Institute of Supply Management (ISM) Non-Manufacturing Index in December was the worst since 2010.
If the trends in productivity growth have remained unchanged since before COVID, as Englander has speculated, then AHE growth will be constant with three to 3.5 percent underlying inflation.
He said it’s unlikely that inflation will become a severe issue if wage growth continues to trend lower at three percent to 3.5 percent per year.
Core service reductions inflation would give the Fed room to slow down or even reverse its aggressive rate-hiking cycle later in the year.
The potential market turning point
George Saravelos, head of FX research at Deutsche Bank, said a more sustained upward trend for the euro could be sparked by this potential market turning point, known as the Fed pivot.
According to Saravelos, the U.S. dollar disregarded historical precedent with the existing growth, inflation and monetary policy mix last year.
The Englishman explained that the risks are moving toward a dollar drop sooner than analysts had thought a few months ago because hostile China and European drivers are becoming more supportive.
Market data suggests purchasing EUR or USD with a target price of 1.10 by Q2 and raising year-end projections to 1.15.
Similarly to Englander’s analysis, Saravelos believe that the Fed will pivot before the ECB due to differences in the length of the U.S. and Eurozone policy cycles.
It’s possible, Saravelos explained, that Europe won’t have a recession this winter, given that the unemployment rate is still falling and government spending is relatively simple.
Since the energy shock in Europe and China’s zero-Covid policy, two of the main reasons why the greenback was seen as a haven last year, seem to have turned the corner, he said this could be vulnerable to more selling.
Saravelos argued that China’s reopening could boost the euro because it is a pro-cyclical currency. Its turning points over the last decade have coincided with a turn in the external growth cycle.
He said tight central bank policy is a significant headwind to global growth. China’s move away from a zero COVID policy is a tailwind, helping prevent upside pressure on the broad dollar via the dollar versus the Chinese yuan rate.