ECB has now stopped QE and has a neutral stance on rates (at least in market’s perception). With Fed expected to be dovish, EUR has a rate advantage over USD and hence can perform better against USD during the first quarter of 2019. But the political situation in EU could again become critical in later part of the year.
The tussle between populist governments (such as Italy’s) and the EU seems to have been resolved, but we believe 2019 would see another flare-up as the ECB is now off QE. Given that France is going to breach the budget deficit limit, most countries in EU would move towards large fiscal deficits in 2019, in an environment where ECB is no longer backstopping their borrowing through asset purchases. One can expect a large jump in yields of various EU countries in 2019 and result in frictions with ECB and EU administration. EUR would get impacted negatively and this would offset any interest rate advantage EUR has over USD. Brexit is a digital event which can go either way, as things stand today. A no-deal Brexit would hurt GBP significantly and can impact EUR also negatively.
EU region has seen signs of impending economic weakness, as evidenced by the recent PMI releases and moderating GDP growth. While the ECB has evinced confidence in the resilience of the EU economy, we believe that the rampaging liquidity provided by the ECB asset purchase plan kept various countries of the EU zone afloat, and with no incremental liquidity in 2019, the year could see a sharp fall in economic indicators of the EU zone. We believe that the ECB would be forced to move to a dovish stance and even resume the asset purchase program in the later part of the year.
EUR could show some strength towards 1.17-1.18 levels as the current USD weakness persists for some months, and markets expect an interest rate advantage for EUR over a dovish Fed. But later part of the year could see a reversal as Fed turns out to be not as dovish and EU growth falters and political pressures come to the fore, expect EUR to retrace the move back to 1.12 and below. QE halt has significant implications for interest rates of the peripheral countries and Italy, and they would find themselves subject to market vagaries as the buyer of last resort is now absent.