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What to expect from the euro in 2018?

Euro strength was one of the big stories of 2017. If we think back 12 months to the start of 2017, the year looked as if it was going to be a particularly tough one for the euro. The eurozone was focused on fears of euro-sceptic triumph in upcoming pivotal elections, whilst investors were still digesting the shock of Brexit, not to mention a surprise win by President Trump.

However, the reality of 2017 for the euro was in fact much better than most predicted. On the political front, the Netherlands kept the far right out of office and voted for the status quo. France voted to keep the euro sceptics at bay and went with the centrist Emmanuel Macron. Angela Merkel managed to win the German elections, although a political vacuum remains as a coalition government has yet to be formed. Finally, Spain managed to make it through a drive for independence from the region of Catalonia. Economically speaking the bloc’s recovery picked up pace and economic growth shifted up a gear.

As a result of more favourable outcomes in many of the risk events during the course of the year, the euro rallied over 12% versus the US dollar and rose strongly versus several of its peers. But can the common currency be expected to have an equally strong 2018?

 

Pockets of political risk still exist

There are still a few unsolved political issues that standout in the eurozone for 2018. The first being the absence of a government in Germany, the powerhouse of Europe.  However, exploratory talks between Angela Merkel’s party CDU and the opposition party SPD are making progress and could be expected to confirm a firmer position in the early weeks of January.

 

Secondly, the vote last week in Spain points to support for Catalan’s independence movement being alive and strong. That said, nothing as close as October’s flare up is on the cards, with any pro-independence coalition government expected to head in the direction of dialogue over threats and a very long windy road to independence. The Catalonia issue has so far put some short term selling pressure of the euro although it has principally shown itself to be a domestic Spanish issue, rather than a eurozone problem. Perhaps not so unsurprising when you consider that the debt that Catalan has with the eurozone is just 4.75% of Spain’s total debt – a significantly different scenario to Greece, for example leaving the eurozone.

 

It’s all about the rates

The big challenge for the eurozone in 2018, could be interest rates. Whilst economic growth projections for the bloc have increased, inflation and interest rate projections are being kept steady. Even in 2020 eurozone inflation is only expected to hit 1.7%, still below the ECB’s 2% target, meaning any rate hikes are still a long way off. In fact, the OECD has even warned that raising rates too quickly could impact on the eurozone’s economic recovery.Should potential eurozone rate hikes be pushed further into the distance the euro could come under selling pressure.

 

Below long-term trend

Whilst the euro shot higher versus its major peers in 2017, it is worth considering that it is still trading significantly below the long-term trend for many of these peers. One such example is the EUR/USD where the longer term trend sits above $1.30 so continued appreciation of the euro would be a return to normalisation.

Given the political and economic outlook, the climate still looks supportive of the euro. A slow steady appreciation could still be expected for the pair in 2018.

 

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