As you can see in the table below, the euro had a bad run in 2016.
And as I’ve marked in the chart below, the euro got three major whippings during the course of 2016.
However, instead of the usual chronological discussion, we’ll discuss the euro’s price action based on its main drivers this year. And these main drivers are as follows:
- The Threat of Brexit
- Threats to the Euro Zone Banking System
- The Threat of Eurosceptic Movements
- The Euro’s Role as a Funding Currency
- The ECB’s Decisions
The Threat of Brexit
Given that some E.U. officials are taking a rather hard stance against the U.K., as well as all this hubbub about the U.K. losing access to the E.U. single market, one gets the impression that the E.U. holds most of the cards when it comes to future negotiations for an actual Brexit.
However, the reality of it is that, with regard to trade with the E.U., the U.K. is a net importer while the E.U. is a net exporter to the U.K.
As of Q3 2016, for example, the trade report from the U.K. Office for National Statistics shows that total exports to Germany, the Euro Zone’s main economic powerhouse, totaled £8,384 million while net imports from Germany amounted to £16,272 million. Total exports to France, the Euro Zone’s second largest economy, came in at £4,757 million while imports came in at £6,115 million, so another trade deficit for the U.K. How about Italy, the Euro Zone’s third largest economy? Well, exports to Italy in Q3 2016 amounted to £2,668 million while imports amounted to £4,246 million. Oh, hey! Another trade gap for the U.K. Okay, how about Spain, the Euro Zone’s fourth largest economy? Well, that’s a deficit for the U.K. as well, with exports to Spain coming in at £2,404 million while imports to Spain total to £4,188 million. Oh, also note that Germany, France, Italy and Spain account for around 70% of the Euro Zone’s GDP.
My main point in all this is to show you that a Brexit, especially a so-called “hard” Brexit where the U.K. loses or has very limited access to the E.U. single market, is actually bad for both the U.K. and the Euro Zone. As such, Brexit fears not only affected the pound, but the euro as well.
This Brexit fear was very prominent during Slide #1, which happens to be in February. And as I noted in my year-end review for the pound, that’s when interest on the Brexit issue began to show.
Brexit jitters were also a major factor during Slide #2, with the “leave” vote during June’s Brexit referendum really putting the hurt on the euro. Heck, as Pip Diddy noted in his recap for the June 20-24 trading week, the euro actually ended up as one of the worst casualties of the Brexit vote, second only to the pound.
Threats to the Euro Zone Banking System
Back in 2015, Grexit, Grexit-related news, and the implication of a Grexit to the Euro Zone financial system, as well as the ECB’s reaction to Grexit, were some of the major drivers for the euro’s price action.
This year, Grexit was in the background, while Italy’s soon-to-be banking crisis was under the spotlight (or on the hot seat, to be more accurate). Aside from the problem with Italian banks, there was also a problem with Deutsche Bank. And these two events were the main reasons for the euro’s weakness during Slide #3.
Let’s discuss the Deutsche Bank incident first. Concerns over Deutsche Bank, Germany’s biggest bank, first emerged in late June after Deutsche Bank failed the U.S. banking stress test again. However, worries over Deutsche Bank only started to take hold during August, thanks to news that Deutsche bank got delisted from the blue-chip Euro Stoxx 50 after failing to meet market capitalization requirements and after reporting a 98% drop in net income in Q2 and losing almost half of its value year-to-date (as of August).
And worries over Deutsche Bank’s financial condition and its negative effect on the stability of the Euro Zone banking system only intensified during the September and October months, since the U.S. DOJ saddled Deutche Bank with a $14 billion fine in order to settle claims that the bank improperly sold mortgage-backed securities, thereby playing a role in the 2008 banking crisis.
This naturally spooked euro bulls and it doesn’t help (the euro bulls) that some European officials were pretty blatant in saying that the fines were a problem. EuroGroup President Jeroen Dijsselbloem, for example, pretty much said that the fines imposed by the U.S. on European banks, and Deutsche Bank in particular, “threaten financial stability of the European banking sector.”
Moving on to Italy’s troubled banks, well, that’s actually not new, dating all the way back to 2013. However, fears that the potential banking crisis would become an actual banking crisis got cranked up ahead of and shortly after the December Italian referendum for constitutional reforms. You see Italian banks have €356 billion in bad loans in their books. And there were fears that a “No” vote and the promised resignation of Renzi in case of a “No” vote (among others) would cause turmoil that would then scare away investors, which would then make the privately-backed recapitalization plans for some Italian banks even more difficult than.
Well, the Italians voted “No” and the troubled Italian banks groaned in pain, with the biggest focus on Monte Dei Paschi, given that it holds €46 billion of the €356 billion worth of bad loans. Moreover, Monte Dei Paschi has to come up with €5 billion by the end of the year or risk getting wound down and potentially triggering an actual banking crisis.
Worries over Deutsche Bank and the Italian banks have abated, though. In the case of Deutsche Bank, it finally reported a profit in Q3 while reportedly agreeing to a $7.2 billion fine, about half of the original amount imposed by the U.S. DOJ. As for the Italian Banks, the Italian government announced a €20 billion bailout plan last week. But on a more downbeat note, the ECB did tell Monte Dei Paschi on Monday that it actually needs to raise €8.8 billion, not €5 billion.
The Threat of Eurosceptic Movements
There were already hints after the June Brexit referendum, but the threat of populist, right-leaning, Eurosceptic movements actually came into play late into the year. To be more specific, market players only began to consider Eurosceptic movements as a real threat to the integrity of the European Union after Trump’s victory in November.
You see, a narrative emerged soon after Trump’s victory, that Brexit and Trump’s victory are signs that populist, anti-establishment movements are beginning to gain support, as Pip Diddy highlighted in his recap for the November 7-11 trading week. This caused fears to flare up that anti-E.U. parties would win the 2017 elections in France and Germany, which will then likely destabilize the E.U. As such, the euro weakened rather hard in the wake of Trump’s victory.
The threat of Eurosceptic movements were also in play during the December Italian referendum, but didn’t have a lot of sticking power after the referendum, since the chance for an early election seems low for now and because former Greens leader Alexander Van der Bellen won out over the right-leaning Freedom’s Party’s Norbert Hofer during the rerun of the Austrian elections, thereby eroding the narrative that populist, Eurosceptic movements are gaining ground in continental Europe.
The Euro’s Role as a Funding Currency
For those who don’t know, the euro is one of the major funding currencies on the planet. The ECB even has a paper discussing the euro’s growing role as a funding currency. Basically, the ECB’s monetary policy means that borrowing in euros is relatively cheaper, so market players borrow in euros to fund higher-yielding investment in, say, the Kiwi dollar or U.S. equities.
And because of the euro’s role as a funding currency, it behaves kinda like a safe-haven currency such as the yen (even though the euro is not really a safe-haven). Therefore the euro usually weakens against higher-yielding or riskier assets/instruments during risk-on times while appreciating during risk-off times. And as you can see below, the euro had a roughly inverse relationship with equities, the DAX in this case.
While not as strong or long-lasting as last year, the ECB’s decisions did have an impact on the euro’s price action
The ECB only acted twice this year. The first was when it slashed rates across the board and expanded its QE program during the March ECB decision. However, the euro reacted positively back then because Draghi said that “we don’t anticipate that it will be necessary to reduce rates further.” This helped the euro to close out the month of March on a high note. After that, the ECB’s monetary policy decision only had an impact on intraday price action, probably because Draghi was true to his word in keeping rates steady.
Anyhow, the second time the ECB moved was when it extended its QE program beyond March 2017 during this December’s ECB decision, albeit at a reduced rate. The extension is about three months longer than expected and Draghi expressed that the ECB can and will further extend or even expand its QE program, if needed, which helped send the euro lower during the first half of December.
Overall, a rather complicated year for the euro, with lots of events in play. Looking forward, the drivers I mentioned in this write-up will likely still be major drivers in 2017.
Deutsche Bank is still in a vulnerable position and the problem with the Italian banks haven’t gone away. Also, we’ve got the French and German elections coming up next year, not to mention the possibility of starting the Brexit negotiations by March. All the while, forex traders will be keeping an eye on how the ECB will react to all these events.
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