Top Forecasters: Deep Cuts in Spain, Italy Will Spark European Recession

Tuesday, 10 Apr 2012 11:21 AM

 

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The most-accurate foreign-exchange forecasters say the euro will slide as austerity-driven spending cuts from Spain to Italy reignite debt turmoil and drag the region into recession.

Nick Bennenbroek, head of currency strategy at Wells Fargo & Co., who topped the list for the fourth time out of the past six quarters according to data compiled by Bloomberg, expects the euro to drop more than 5 percent to $1.24 at the end of 2012. Westpac Banking Corp., which had the second-lowest margin of error, predicts $1.26.

The euro’s biggest quarterly gain in a year will prove fleeting. The economy faces “downside risks” amid rising Spanish and Italian borrowing costs, European Central Bank President Mario Draghi said on April 4. The benefits of record ECB loans to local banks, which helped drive yields down from euro-era records, are fading and the region faces recession, while the U.S. expands at the fastest pace in two years.

“One of the reasons the euro gained was that we saw some progress in the European debt crisis and some improvement in European bond markets, and we’re near the end of that,” Bennenbroek said in a telephone interview in New York on April 2. “The euro will weaken further as slow to no growth weighs on sentiment and as ECB actions continue to weigh.”

The euro strengthened 0.2 percent to $1.3131 as of 1:22 p.m. in Tokyo and gained 0.1 percent to 106.90 yen. The dollar fetched 81.40 yen from 81.49 yesterday.

First Quarter Gain

The 17-nation currency strengthened 2.95 percent in the first quarter as the European Union arranged a second bailout package for Greece after the nation negotiated a debt-swap with its private-sector investors, and as the ECB provided a record amount of loans to the region’s banks. The actions reduced investor concern that the crisis would spread.

Austerity measures across the region are driving the economy into a recession, spurring concern the ECB may introduce further easing measures, according to Richard Franulovich, a senior currency strategist at Westpac in New York.

“Europe’s going through deleveraging, austerity, and growth is very poor,” he said in an April 3 telephone interview. “So you have a situation where the ECB could be easing and the Fed is basically on hold, and that should mean interest-rate differentials move in the dollar’s favor.”

Rise to Resume

The next three most-accurate forecasters see euro gains continuing. Jane Foley, a London-based senior currency strategist at Rabobank International and the fifth-most accurate, said the euro may rise as the Federal Reserve keeps interest rates at a record low and the U.S. moves to cut its budget deficit after presidential elections in November.

Employers in the U.S. added 120,000 jobs in March, the fewest in five months, Labor Department figures showed on April 6 in Washington. The March increase was less than the most pessimistic forecast in a Bloomberg News survey, in which the median estimate called for a 205,000 gain. Unemployment declined to 8.2 percent, the lowest since January 2009, from 8.3 percent.

“The labor market recovery is still slow and the unemployment levels very high,” Foley said in a telephone interview on April 3. “If there is any degree of fiscal cleanup after the election, then that will be a drag on growth and monetary policy will have to remain accommodative for longer.” The euro will probably trade at $1.35 in nine months and climb to $1.40 a year from now, she said.

JPMorgan Chase & Co. and Oversea-Chinese Banking Corp., the third and fourth most-accurate forecasters, predict the euro will appreciate to $1.36 and $1.35, respectively, by year end.

“We still expect risk for the euro to be on the downside,” Emmanuel Ng, a currency strategist at OCBC in Singapore, said by telephone yesterday. Ng expects the euro to be at $1.30 at the end of June.

Euro Support

Europe’s common currency will remain supported as Spain and Italy are unlikely to require financial aid and the U.S. isn’t growing fast enough for the Fed to start raising interest rates, according to John Normand, head of currency strategy at JPMorgan, the biggest U.S. lender.

“There are enough mechanisms to allow countries like Spain and Italy to retain market access even if they may have to roll over debt at higher interest rates for a period,” London-based Normand said in a telephone interview April 5. “It’s difficult to look at the balance of data emerging from the U.S. and conclude that the Fed will prepare the ground for rate hikes.”

While the Fed has said it would keep its range for overnight bank lending at zero to 0.25 percent through 2014, it’s holding off on increasing monetary stimulus unless the U.S. economic expansion falters or prices rise more slowly than its 2 percent target, according to minutes of the central bank’s March 13 meeting released on April 3. Fed Bank of Richmond President Jeffrey Lacker said a day later that U.S. economic growth next year may warrant a rate increase before 2014.

Recession Seen

Europe’s emergency stimulus won’t end soon, Draghi said at a press conference after the ECB’s April 4 meeting. It’s premature to talk about an exit strategy, he said, adding that inflation will remain contained in the medium term.

The euro area is headed for a contraction of 0.4 percent this year, after 1.5 percent growth in 2011, according to the median estimate of 20 economists in a Bloomberg News survey. That compares with growth of 2.2 percent in the U.S., the fastest since 2010, as forecast in a separate survey.

Strategists expect the ECB to keep its main refinancing rate at 1 percent through at least the third quarter of next year, while the Bank of Japan’s main rate will be 0.1 percent by the end of that period, separate surveys show. The BOJ kept its key rate and stimulus programs unchanged after a meeting today.

Investors may have overestimated developed nations’ readiness to raise rates and reverse loose monetary policy, according to Royal Bank of Canada, which had the most accurate dollar-yen forecast.

Yen to Rise

“There’s an unrealistic expectation of how early central banks will tighten in the world outside Japan,” Adam Cole, global head of foreign exchange strategy in London at the firm’s RBC Capital Markets unit, said in an April 4 telephone interview. “If the market moves to reflect that and we see two- year yields in the U.S. and the rest of the world come down back toward Japanese levels, the upward pressure on the yen will reemerge.”

Two-year yields on Japanese bonds are at 0.11 percent, just below the one-year average of 0.15 percent. The difference between the Japanese yields and similar-maturity U.S. yields is 0.20 percentage point, up from as low as 0.08 percentage point this year in January. The spread between the Japanese securities and German two-year yields was 0.02 percentage point, after the yields were almost the same earlier this year.

Cole said the yen will appreciate 10 percent to 73 per dollar by the end of the year and by 15 percent to 93 per euro.

Spanish Yields

Public borrowing in Spain will balloon to a record 79.8 percent of gross domestic product this year, according to the 2012 budget that the government presented to parliament April 3, as the nation finances a deficit that was almost three times the euro-area limit last year.

Spain’s 10-year bond yield has jumped about 85 basis points, or 0.85 percentage point, since Prime Minister Mariano Rajoy said on March 2 that the government budget deficit would miss the 4.4 percent of GDP target the previous administration had agreed to with the EU. Spain agreed to set the target at 5.3 percent March 12.

The additional yield investors demand to hold Spanish 10- year bonds instead of similar-maturity German bunds, the region’s benchmark government securities, climbed to more than 400 basis points last week, reaching the most since Nov. 30.

Borrowing costs for Spain are at December levels, before the ECB’s unlimited three-year bank loans were first allotted on Dec. 21. Some of the 1 trillion euros taken in the longer-term refinancing operations, or LTROs, has been recycled into government debt, which helped shave as much 1.44 percentage points off the 10-year yield before it began to rise in March.

Short Bets Increase

Italian Prime Minister Mario Monti faces strikes against austerity measures and his labor-reform plan, which allows companies to fire workers for economic reasons without letting courts reinstate them, is dividing his ruling coalition. The Democratic Party, which has supported the prime minister’s four- month-old government, has pledged to change the rule in parliament, even as Monti has said he won’t permit it.

Futures traders have been short the euro, or betting on a decline in the common currency, for 32 straight weeks, the longest such period since 2010.

The difference in the number of wagers by hedge funds and other large speculators on a decline in the euro compared with those on a gain -- so-called net shorts -- was 79,480 in the week ended April 3. Net longs were 99,516 in May 2011, as the Fed was ending its $600 billion bond-buying program.

‘More Compelling’

“The macro picture is slowly but surely turning more compelling for the dollar,” said Westpac’s Franulovich. “The U.S. growth picture is much more secure than Europe’s.”

Strategists were ranked according to the accuracy of their estimates for 13 currency pairs in each of six quarters beginning with the three months ended Dec. 31, 2010. To test long-term accuracy, Bloomberg Rankings added one annual forecast, which was made in March 2011 for March 2012.

Only firms with at least four forecasts for a particular currency pair were ranked, and only those that qualified in at least eight of 13 pairs were included in the ranking of best predictors. Thirty-one firms qualified.


© Copyright 2014 Bloomberg News. All rights reserved.

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