What does the Euro trend reversal imply?
The Euro is trading at thirteen month highs against the USD as of 31st January 2013. The single currency shared by seventeen nations in the Euro Zone has gained over 12% from lows seen in July 2012 and is up over 2% month on month as of 31st January 2013. The Euro is currently trading at levels of EUR 1.357 to the USD, up from lows of EUR 1.207 seen in July 2012. Will the Euro continue to strengthen against the USD or will it see a reversal as the Eurozone economy falters in relation to the US economy? What does a rising Euro mean for the Sensex, Nifty and INR?
The rise in the Euro has been accompanied by a sustained rise in the Sensex and Nifty (Chart 1) that have returned over 18% each since July 2012. The INR too has strengthened by 4.7% since July. One primary reason for the rise in the Euro is the heavy bets that were placed on the Euro weakening as the Eurozone sovereign debt crisis threatened to erupt in 2012. The fact that the crisis was averted by actions of multiple institutions participating in defusing the crisis including the ECB (European central Bank) prompted a large scale unwinding of Euro shorts leading to the sharp uptick in the Euro.
The Eurozone debt crisis was also threating to pull down equities with money managers being short in equities in conjunction with the Euro shorts. The aversion of the crisis resulted in large scale short covering in equities across the globe with the German Dax being the best performer since July 2012 with a 22% gain. The Sensex and Nifty too benefitted from the Euro led short covering.
The question to ask is whether the Euro is reflecting improved Eurozone fundamentals or whether it is just short covering? Eurozone fundamentals are weak with unemployment at record highs of 11.8% as of November 2012 and the Eurozone economy contracting by 0.1% in the third quarter of 2012. Forecasts for the Eurozone are not optimistic with the economy expected to just about stay above waters in 2013. Bailout countries including Greece, Spain and Portugal are struggling to keep their economies afloat due to the stringent terms of the bailout. Eurozone fundamentals do not suggest a large scale move towards the Euro even though the economy is said to have seen the worst.
The US economy contacted by an annualised 0.1% in the fourth quarter of 2012, well below expectations. The GDP growth number came as a surprise to the market as all US data from housing to labour were pointing to an improving economy. US is forecast to grow at around 3% in 2013 by the rating agency Standard and Poor’s, up from earlier forecast of 1.8%. US grew at 2.2% in 2012 outstripping Eurozone growth.
The weak fourth quarter GDP growth number in the US has the markets now expecting the US Federal Reserve (Fed) to continue its USD 85 billion per month of bond buying program. The Fed’s policy rates are at close to zero per cent against the ECB policy rate of 0.75% and the Fed is expected to maintain low rates well into 2014. The Fed policies are seen as Euro positive.
Euro will stabilize and that will be positive for Sensex, Nifty and INR
The Euro will have seen most of the risk aversion out of its price at levels of EUR 1.35 to the USD. Going forward, the Euro is most likely to top out at current levels (plus 3% rise) as growth differentials between Eurozone and US will stay high. However it is unlikely that markets will risk fear trades on the Euro as the worries on the Eurozone debt crisis ebbs away.
A fear free Euro is positive for the Sensex, Nifty and the INR as global investors increase risk appetite on the back of the Fed maintaining easy monetary policy to pull up the US economy.
Table 1. Market Movements