Good morning

Following on from yesterday’s comments FX rates and FX in general back in the limelight (ignoring FX volatility for now) as economic numbers recently published all showing conflicting data.

Eurozone back in the doldrums after the economic recovery ground to a halt across the region and France demanded a radical shift in policy. Furthermore, the French sounded out an early warning shot that austerity overkill is driving Europe into back into a depression. Growth fell back to zero in Q2, while Germany contracted by 0.2%.  Italy is already in a triple-dip recession having contracted at -0.20% for the previous 1/4. Yields on 10-year German Bunds fell below 1% for the first time in its history (currently 1.01%), beneath levels seen during the most extreme episodes of deflation in the 19th century. French yields also recording record lows currently trading at a yield of 1.40% (10yr).  Much of the Eurozone is mirroring the pattern last seen in Japan as it slid into deflation in the late 90’s.

 Crumbling yields are primarily a warning signal that stagnation could be around the corner or a bet by investors that the ECB will soon be forced to launch quantitative easing (QE) and buy government bonds across the board. French Finance Minister fired a warning shot that France would no longer try to meet its deficit targets and in so doing inflict any further damage to its economy. He stated that “Growth is too weak in Europe and inflation is too low. We must therefore stop reinforcing the causes of this depression.”

The collapse of economic recovery in Europe leaves the ECB in a delicate position. Gov. Draghi offered no clues last week on when the ECB might finally resort to QE, insisting that it will wait to gauge the full effects of its negative deposit rate and the result of new loans to banks in September and December. This delays any likely QE until at least early 2015. European banks are nevertheless downsizing their lending (to customers) to meet their new capital ratios. Having said that the IMF said QE is a far more powerful instrument. Gabriel Stein, from Oxford Economics recently commented “The ECB will do as little as possible in the hope that something will come along to save them, and the euro will weaken. They are desperate not to do QE.”

What this all means for the FX rates is (as I see it) a complete turn-around in fortunes. I commented months ago that any recovery in Europe is wholly dependent on a full recovery in the USA. One of the ways to aid this recovery is to make European goods more attractive (financially) by letting the EUR weaken. We have seen this pattern in play now for the past 6 weeks as the EUR (USD) has fallen from 1.37’s to the current levels of 1.34. I have said over and over again that this is just the start and we are likely to see a much greater reversal as we head into Q3/Q4. It is no longer a matter of IF but WHEN the next leg of the EUR collapse will start in earnest.

Having said that I do not believe (despite the recent move) the GBP will suffer the same fate. The reason is quite simple, the UK economy is thriving compared to its European neighbours. This difference (in GDP) will in my opinion continue to give the GBP an upper hand over the EUR especially. Vs the USD I believe the fall will be less extreme and in fact once we have a better idea of when rates are likely to rise the GBP should recover against the USD.

Time will tell!!!!

Have a great weekend