- Under pressure from the German President, SPD reconsiders its opposition to a coalition
- Politics may become a tailwind for the euro, as support for Macron's vision grows in Germany
- Growth, monetary policy and sentiment help the euro today, but may become a headwind in 2018
After the collapse of German coalition talks last week, the euro took the news in stride. At the time, we wrote that strong GDP growth is the primary driver behind the ongoing euro bull market. Despite the obvious significance of political instability in Germany, the most important economy in the Eurozone, the impact was unlikely to be felt in the short-term. While EUR/USD ended the day weaker (around 1.1740), the currency pair has since strengthened beyond 1.190 as of today. Looking at the future outlook of the euro, the latest news regarding another potential ‘grand coalition’ between the CDU/CSU and SPD is supportive for the currency. Beyond German politics, key drivers of the euro suggest that the medium-term outlook remains bright.
Eurozone politics: a tailwind?
The SPD’s recent announcement that it is willing to entertain coalition talks with Merkel’s CDU/CSU party is a remarkable change from its earlier position. Following the elections, SPD leader Schulz repeatedly denied the possibility of another grand coalition. More specifically, he claimed that the outcome of the vote represented the German electorate’s rejection of the previous coalition government. Following pressure from German President Steinmeier (a member of the SPD and a former minister in Merkel’s government), Schulz appears to have relented. While both Merkel and Schulz were calling for new elections last week (polls suggest a majority favor snap elections), another grand coalition is looking more likely today.
While the formation of another ‘grand coalition’ is far from certain, it would be supportive for the euro. This is because a coalition government including the SPD is more likely to support deeper integration with the EU. Unlike the FDP, the Social Democrats are supportive of ideas such as an EU finance ministry (with a dedicated budget) to coordinate economic policy. As Merkel becomes a weaker force in German politics, Macron’s push for deeper integration amongst EU members is looking more and more likely. Once a headwind for the euro, politics may become a tailwind.
Growth and monetary policy: hawks close by
More importantly, GDP growth in the Eurozone remains strong. After delivering GDP growth of 1.7% in 2016, 2017 growth looks set to exceed 2%. The performance of the Eurozone economy is especially impressive considering tough base effects (mathematically, year-over-year growth is harder when historical growth is high) and the impact of a stronger euro in 2017. In recent weeks, forward-looking growth indicators including retail sales, consumer confidence and PMIs have met or exceeded estimates. After 2.5% GDP growth in Q3, economic data suggests that Q4 2017 GDP growth is likely to remain strong.
As Eurozone growth booms, the ECB’s current quantitative easing program looks out of date. While the Bank is not expected to modify its bond buying program until the second half of 2018, expectations for the program to be curtailed are growing.
Both strong GDP growth and expectations of tighter monetary policy are positive for the euro. While GDP growth won’t accelerate forever (the outlook for 2018 is much tougher due to base effects), the euro can keep rallying in the medium-term.
Sentiment: stretched but not at extremes
Lastly, speculator sentiment is outside extremes today. While net long positions in the euro were looking extended prior to the ECB event (and at risk of a reversal), this is no longer the case today. Looking at 3-year z-scores, they remain below two standard deviations from historical averages. Historical net positions in futures and options versus 3-year z-scores are shown below:
Room to rally: net euro longs fall from bullish extremes
Speculator positions were last at an extreme in late October, prior to the ECB meeting. Following the ECB event, net long positions fell and are thus are less likely to be at risk of a sudden reversal today. As positions are outside extremes, speculator sentiment is not yet a headwind for the euro
Enjoy the rally while it lasts
While the way forward for the euro looks bullish in the short and medium-term, the longer term outlook is cloudier.
In 2018, we expect Eurozone GDP growth to slow (thanks to base effects) while the ECB is likely to tighten monetary policies and assume a normalization path. At some point in the near future, speculator sentiment towards the euro is also likely to become very crowded if economic growth stays strong. Given the poor outlook for the US dollar (a topic we covered earlier today), long euro risks becoming a consensus favorite.
For now, our outlook on the common currency remains bullish.