While Europe experienced tension and wars between neighbouring countries for centuries, nations finally decided to come together to create a political and economic powerhouse – the European Union - that could compete with global powerhouses.

The European Union represents a merging of cultures that have presented more than a few problems over the past two decades.

In 2019, the EU faces a continuation of weak economic growth and political problems. While the euro currency began trading at the turn of the century at par to the US dollar, the euro rose to a high at $1.5988 in 2008.

Since then, the European currency has made a series of lower highs and lower lows, and was trading at the $1.1314 level this week. At this point, there are lots of reasons why the euro could be heading back to par against the US currency.

More than a few issues facing the European economy over the coming weeks and months could cause volatility in the euro as the European Central Bank (ECB) continues to try to manage the economy through tempestuous economic seas.

Sluggish Eurozone Growth

In the US, economic growth has picked up dramatically since 2016 as tax and regulatory reforms by the Trump administration have served as fiscal stimulus.

In the face of interest rate hikes that pushed the Fed Funds rate from zero to 2.25-2.5%, fiscal stimulus has taken over from the monetary policy accommodation that held the US out of a prolonged recession. Many economists predict that the US economy will grow by 2-2.5% in 2019.

Meanwhile, one cannot say the same for the European economy. Germany is the leading economic power within the European Union. In 2018, the German GDP rose by 1.4% as it lagged the US.

Last week, the German government slashed its forecast for 2019 to only 0.5% (which is the lowest level of growth in six years).

Sluggish economic growth in Germany and the rest of the members of the EU almost guaranty that monetary policy from the ECB will remain highly accommodative.

Rates remain in negative zone

Short-term interest rate hikes started in the late 2015 in the US, and by the end of 2018, the Fed increased rates by 25 basis points a total of nine times. Even though the central bank cancelled rate hikes for the rest of 2019, the rate remains at 2.25-2.5%.

At the same time, the Fed announced the program of balance sheet normalisation would end in September 2019 with just over $3.5 trillion of debt on their books. The Fed only purchased government debt securities during their quantitative easing (QE) program.

Quantitative easing and slashing rates occurred in Europe as well, but they went two steps further. Short-term European rates fell to -40 basis points, and the ECB not only purchased government debt issues but some high-quality corporates to stimulate the economy.

While the US shifted from accommodation to tightening credit, the ECB did not follow the Fed when it comes to monetary policy. Mario Draghi, ECB president, and his colleagues have kept short-term rates at -40 basis points, and while QE ended in 2018, there are no plans to reduce their swollen balance sheet.

The bottom line is that one of the leading factors when it comes to the path of least resistance for the value of one currency versus another is the differential between short-term interest rates.

While short-term dollar yields have stopped increasing with the same trajectory, they were in 2018, the difference between the rate the Fed pays for a short-term deposit and the negative yield charged by the ECB stands at 2.65-2.9%.

The interest rate advantage for the dollar points to a continuation of the bearish trend in the euro versus the former.

Brexit and southern Europe

The EU recently granted an extension on the Brexit deadline to the end of October 2019.

Given the recent stalemate between the UK Parliament and the EU over the terms for an amicable divorce from the union, there appears to be no deal in sight which could continue to weigh on the value of the euro as uncertainty is never a good factor when it comes to the value of a reserve currency.

The southern countries continue to pose problems for the leadership of the EU in Brussels and ECB in Frankfurt. The almost constant threat of default by weaker economies within the union means that bailouts have become the norm rather than the exception which reduces the value of the Euro.

At the same time, the prospects for a trade battle with the Trump Administration over automobile exports from Europe into the US is another threat to the European economy. The blatant political and economic realities facing Europe create smoke clouds when it comes to the value of the euro currency.

This article was issued by Maria Fenech, investment management support officer at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.


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