© Michael Hewson
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I think we will have to get used to some disappointments, and we got an early flavour of that with the latest flash PMIs from France and Germany, which both missed expectations. Germany missed by not so much, and what was really worrying was the sharp drop in French Flash Services PMI data. A slight improvement from January was expected; however, we saw a sharp drop to 46.9 from January's 48.9. Flash Manufacturing PMI was also very disappointing and in my opinion that is a real concern going forward. Despite the fact that we have seen an improvement across Europe, the better-than-expected economic performance has been more marked in some of the weaker European countries like Portugal and Spain, who are already undertaking reforms. Although, France has not even started reforms, their private sector PMI is starting to fall back very sharply. The concern is that France needs to take steps to deal with these issues and they are not doing that. In my opinion, that might really push the Euro lower.
Mario Draghi has stated that even though there is a low level of inflation and most likely it will be so for a protracted period of time, there is no risk of deflation. What are your thoughts on this matter and do you agree with Mr. Draghi?
I believe that the single currency union rebalancing process will lead to a certain amount of deflation caused by decreasing unit labour costs, and to my mind it is inevitable. If unit labour costs and prices are higher in one country compared to other, then the fiscal adjustment needs to be done independent of the currency. A country cannot just devalue the currency because it is in the single currency block; therefore, the only way how to do that is by pushing prices down in the countries that are uncompetitive. Certainly, I expect that there will be an element of deflation in terms of pushing price pressure down. We are seeing that in countries as Greece and Portugal, which are still undergoing an adjustment process. Although, when countries like France start do that, price pressures are going to fall, thus there will be certain amount of deflation and that is necessary to make the adjustment process happen. I do not think that there is a problem with deflation; however, the Eurozone will have to put up with the prolonged period of the low target inflation. Otherwise they will not be able to make the necessary adjustment that are needed.
What kind of events and decisions could determine the Euro performance?
I believe there will be a lot of emphasise on what the European Central Bank does in its March meeting. Given the fact that we have seen an improvement in the economic data thus far I would assume that some pressure to cut interest rates is receded. Unfortunately for Mr. Draghi I do not believe that cutting interest rates is going to solve the problem. At the moment, the problem within Europe is the banking sector. While banks have to start to sort their balance sheets out in line with Asset Quality Review, they get very reluctant to lend. In my opinion, the Euro is probably going to continue to remain fairly strong unless the ECB embarks on a larger scale QE programme.
Also the other side of the coin is what the Fed is going to do at its March meeting. The expectation is for the Fed to taper further $10 billion in March. If it does not, then that could keep the floor under the Euro and help pushing it back towards 1.40 and that is really a concern right now. To sum up, the biggest drivers for Euro will be the ECB's ability to ease further and the Fed decision to taper its asset purchase programme.
What are your short and longer term forecasts for EUR/USD and EUR/JPY?
I expect that in short to medium term EUR/USD will remain fairly strong and I see it trading in a range between 1.33 and 1.38. I do see this pair being slightly weaker and there is pretty much the same sort of targets for EUR/JPY as well. Despite the fact that there are obvious problems within the European currency, area I think that Euro weakness will be fairly limited. I would suggest EUR/USD trading around 1.35 in a month time and 1.34 in three months, while EUR/JPY will trade around 135 in a month and 132.65 in three-month time.