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. 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.