The euro has dropped almost six cents since the knee-jerk post-election bounce to $1.1300. The immediate driving force is the anticipated policy mix in the US. With the US economy already growing near the trend pace, and the Federal Reserve’s objectives of full employment and price stability (defined as 2% increase in the core PCE deflator), the central bank was already poised to lift rates.
The fiscal stimulus that Trump’s economic advisors have not backed away from is $1 trillion. Former Treasury Secretary Summers, a long-time advocate of deficit-financed infrastructure investment objects to the mix of the tax cut and new spending, but the magnitude is nevertheless breathtaking.
While most economists are focusing on either the higher US interest rates and a likelihood of a somewhat more aggressive Fed tightening cycle, or the possibility of a dramatically more stimulative fiscal stance. We see the combination (the policy mix) as an exceptionally potent force that will continue to propel the dollar higher.
Interest rate differentials provide an incentive structure for investors. Investors are paid to be long the dollar against most major currencies. This also means that for any given level of volatility, it is cheap to hedge European or Japanese exposure.
On top of these macroeconomic forces, we suspect political factors are also aligned against the euro. The European project is predicated on the weakening of nationalism and the perceived benefits of integration. Many observers see in the UK referendum and the US election forewarning of the centrifugal forces that undermine European integration.
Although there are a number of potential flashpoints in Europe, the two that are capturing investors’ imagination is the Italian referendum in early December and the French Presidential election next Spring. Renzi had backed away from his early promise threat to resign if his constitutional referendum (on reducing the size and function of the Senate) failed. However, over the weekend, he hinted again that he might resign. To be sure, polls suggest the referendum, which is opposed by all the opposition parties and some members of Renzi’s coalition, will likely fail to garner majority support.
There are many challenges if Renzi resigns. The political reform efforts have begun, but without the changes to the Senate, the earlier changes will have to be revisited. Renzi is the third unelected Prime Minister. His replacement would be the fourth. Elections are not slated until 2018, and the second largest party in Italy is the 5-Star Movement, which wants to have a referendum on continued EMU membership.
In France, the center-right Republican Party will hold the first round of its first primary this coming weekend. A second round run-off will be held the following weekend. It is important because the winner is most likely to face Le Pen in the second round of the French Presidential election in the Spring. Hollande’s Socialist Party is suffering in the polls. His support is in single digits.
Where does that leave the euro? This chart is a month bar chart of the euro, and Bloomberg uses a synthetic calculation to capture its value before EMU. The euro peaked in 2008. From 2008 through mid-20014, the euro traded in a broad range between $1.20 and $1.50. After 2011 though, it was capped near $1.40. The euro broke down in H2 14, and since early 2015 has moved in a narrow $1.05-$1.14 range with a few exceptions.
We anticipate that the consolidation will be resolved with another leg lower. On the chart, we drew a trendline of the synthetic euro low during the Reagan dollar rally (~$0.6445) and the low of the Clinton dollar rally (~$0.8230). That trendline comes in near $1.000 by the end of the year. That roughly coincides with a 61.8% retracement of the euro’s rally from the 1985 low to the 2008 high (~$1.01). A break of that area, which is also of psychological importance, would open the door to a fall toward $0.8200-$0.8700.