Leaving aside events in Cyprus earlier in the year, this was the first year since the Greek bailout in 2010 that the single currency was not jumping from crisis to crisis. In the background, Draghi’s infamous pledge to do “whatever it takes” in the summer of 2012 (backed up with the OMT programme) provided a strong structural support to the euro. It meant that the market could move on from obsessing about Italian and Spanish bond yields.
The extent to which structural problems are being solved or just being pushed in into the future (let’s not mention cans) remains valid. I don’t see this being resolved in 2014. Instead the impact of anaemic growth, low inflation (deflation in some of the periphery) will be shielded by the presence of the OMT, together with further policy measures from the ECB (more liquidity, negative deposit rate). Outright QE remains intellectually appealing, but operationally questionable and politically unacceptable, especially in Germany.
The often asked question is whether the worst is over? Probably not is the answer. Most likely 2015 will be more painful than 2014 as the impact of higher bond yields globally impinges on the funding costs of both peripheral and some core markets. The politics is complicated, but the economics is a lot easier. Debt crisis are only really solved via inflation, currency devaluation or default and most likely a combination thereof. Low growth and fiscal policies are limiting inflation (and threatening deflation in some cases), the second is not an option and default remains politically unacceptable, bar the restructuring seen in Greece.
But internal devaluation, seeing lower inflation in the periphery vs. the core is an imperfect cure for two reasons. Firstly, it needs to be matched by labour costs, which has happened in Ireland, is happening Greece, but is absent in Italy (and also France). Secondly, it comes because of Germany’s intolerance of high inflation (for structural and historical reasons).
Picking holes and issues in the make-up of the eurozone is easy. Translating this to currency implications is easy, not least because the euro is unique in its design, going through a period unique in recent financial history. Two things have stood out in recent months. Firstly, the euro performed relatively well during the tapering scare. Emerging markets were under pressure, especially those with current account deficits and/or near-term funding issues. The euro benefited from this to a degree. Secondly and more recently, the euro also performed well in the wake of the November easing.
I outlined in November the more bullish case for the euro (see “Why the euro will do well”). In brief, history suggests that low inflation, low rates, with positive and rising current account surplus has tended to be a positive backdrop for currencies. Further easing measures will have limited impact on market rates, so will also not be that negative for the euro. Even with tapering, after the initial dollar bounce, the euro should continue to perform well in the early part of 2014 and even when dollar strength is more broad-based, the euro will continue to outperform both sterling and the yen.