The Euro has fallen to two year lows on economic woes in the Eurozone. The seventeen nation currency is trading at a two year low against the USD at Euro 1.245 levels, down over 14% over a one year period and down 6.6% end March 2012 to date. The weak Euro is in turn affecting assets classes of equities, commodities and emerging currencies. Table 1 shows the effect of a weak Euro on other asset classes.
The 6.6% fall in Euro against the USD since end March 2012 to date has been accompanied by a rise in the USD index and fall in equity indices from the German Dax to the Indian Nifty. The USD index, which tracks a basket of seven major currencies has strengthened while the Indian Rupee (INR) has fallen close to 10% against the USD. Commodity prices have fallen with the Reuters Jefferies commodity index down over 9% and gold down by over 7%.
Euro will further weaken
Euro will continue to weaken and is likely to go down to levels of EUR 1.15 against the USD, a fall of 8% from current levels. The reason the Euro will weaken is that economic conditions in the Eurozone will continue to deteriorate while worries on debt of Spain will weigh on the currency. The ECB (European Central Bank) will pump in more money through the LTRO (Long Term Refinancing Operation) leading to the markets being flooded with Euro liquidity, which has the effect of weakening the Euro.
The Eurozone economy showed zero growth in the first quarter of calendar 2012 and is expected to go into mild recession in the coming quarters on the back of austerity measures adopted by large economies such as Italy, France and Spain. Eurozone GDP growth contrasts with the US GDP growth of 2.2% seen in first quarter 2012 indicating the strength of the US economy relative to the Eurozone.
Spain is struggling with its debt and its ten year bond yield at 6.5% is threatening to breach the psychological 7% levels, where debt servicing becomes unsustainable. Spanish banks with exposure to real estate loans in a bubble burst property market are under scrutiny for their balance sheet weakness. Euro is being dragged down on debt woes of Spain. Greece is always a threat to the Euro and the threat will not go away unless Greece exits completely or toes the EU line on austerity.
The ECB, which has already pumped in over Euro one trillion into the system through the two LTRO’s done in December 2011 and February 2012, will be forced to do more rounds of LTRO’s to stabilize the banking system and prevent bond yields of Spain and Italy shooting up. ECB will also be forced to play a role in the new growth target plans set by the EU. ECB will flood the system with Euro liquidity, thereby weakening the Euro further.
Will other asset classes continue following the Euro down?
The trend of weak Euro bringing down assets classes of equities and commodities and taking up the USD index will see some breakaways. Equities, especially US equities will tend to go higher on the back of a more resilient US economy. The fact that the US Fed has kept rates low and liquidity high in the system and has refrained from more quantative easing is helping the US economy as well as the USD. US is adding jobs every month and its unemployment rate is down to 8.1% from levels of 9.5% seen in 2011. Rising US equities will have a positive effect of other equity markets, as it is a sign of resilient corporate performance in the face of weak macro economic trends. Nifty will see stability at lower levels, with bottom being formed around 4800 levels.
Emerging currencies that have tracked the Euro down will also see bottoms forming at lower levels. The interest rate differentials with the US will help currencies such as the INR. The wide 8% difference between the US Fed fund rate and the Repo rate will help keep the INR steady at lower levels, though volatility will be high due to a continuously falling Euro. Markets will also have a tendency to start using the Euro for carry trades by borrowing cheap Euros at 1% ECB rate and investing in higher rate bearing currencies such as the INR.
Commodities will continue to fall as the Euro weakens, as drivers of commodities including a weak USD and strong economic growth are absent. Falling commodity prices will help net oil importers such as US, Japan, China and India while countries such as Russia that are completely dependent on oil exports will face the heat.
