A Euro Slump Is More Likely Than A Recovery

Welcome to a new and crucial trading week.

The European Central Bank is expected to begin raising interest rates this month for the first time since 2011. The ECB’s decision and press conference are scheduled for Thursday.

After years of low inflation, the ECB is now confronted with a price spike that forces policy makers to join the kind of aggressive policy tightening deployed elsewhere. In a normal world, aggressive monetary policy tightening would buoy the euro but the risk of a euro-area recession is now seen at 45 percent, up from 30 percent in June. Apart from the eurozone’s gloomy outlook we also have to understand the role of the U.S. dollar.

The dollar’s gain is the world’s pain. A stronger U.S. currency has historically translated into a broad hit to the world economy. Higher-than-expected inflation has forced the Federal Reserve to hike rates at the fastest pace in decades and this kind of aggressive tightening has supercharged the U.S. dollar. Tighter U.S. monetary policy tends to boost inflation elsewhere because of the currencies that weaken against the dollar. Additionally, there is a European problem which sends the euro lower and the dollar higher in return and worsens the manufacturing cycle. Germany faces a double whammy as soaring natural gas prices also cut into its manufacturing sector. Germany’s economic growth model was for decades built on cheap Russian energy and without German growth the outlook for the Eurozone could be dark. As for the Fed and with U.S. inflation standing at 9.1 percent, the central bank has little room to reverse course on its tightening mode to provide some relief to exporters and leveraged borrowers around the world.

What is expected from the ECB on Thursday?

A 25bp hike this month is described as a done deal, followed by a 50bp move in September and 25bp increases in October and December. However, with Eurozone annual inflation currently at 8.6 percent a larger-than-expected hike may be needed. The question of 25 or 50 basis points, already controversial, would have been the main issue by now were it not for an outbreak of Italian debt turmoil that forced ECB President Christine Lagarde to hold emergency talks and extract a pledge for a new tool. The ECB will want to keep Italian borrowing costs under control in an effort to spur economic growth. The political turmoil in Italy could thus complicate the European Central Bank’s efforts to raise interest rates.

Whatever happens, a further slump in the euro is more likely than a recovery.

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