European Deflation Battle Success Hinges on Unity in 2015

The euro lost 9.65% of its value versus the U.S. dollar in 2014. The American economy’s growing momentum coupled with the growth-sapping effect of European deflation has driven the EUR/USD to a two-year low (1.2260). To find a lower quote, we need to go back to the summer of 2012 when the Spanish bailout rumors drove the EUR (1.2171), and the five-year low it hit in the summer of 2010 (1.2020). The lower support levels are under threat if the European Union cannot achieve consensus on much needed reforms.

Europe joins Japan and China among the major economies looking for ways to foster a faster pace of growth. The United States and the United Kingdom have shown impressive growth, and each are six months away from ending an era of record low interest rates. The global growth slowdown and various geopolitical threats will make for a challenging 2015 for the single currency.

ECB to Do Whatever It Takes (or Whatever Germany Allows)

The European Central Bank (ECB) by design has never been the first central bank out of the gate with effective monetary policy. Arguments have to be made, options weighed, and consensus built before any decision is made. It is done at a pace that favors patience over action. The ECB has countered this frustratingly slow process with combative rhetoric. More than once, President Mario Draghi has vowed to do whatever it takes to defend the euro. Like the boy who cried wolf, the markets are now unsure if he could really do anything unless Germany supports his proposed measures. Something’s got to give. Record low interest rates, stagnant economic growth, and deflation are hammering the eurozone.

Deflation will reduce consumption, as prices stay low the longer consumer spending is flat. This creates a vicious cycle where growth remains elusive, and internal demand continues to be driven down, thereby reducing the overall growth of the economy. Even the German engine has begun to stall with the adverse conditions within Europe. Adding to the brooding sense of economic woe, macroeconomic headwinds courtesy of sluggish growth in China and Japan is to the currency bloc’s detriment.

The main challenge for the ECB is to convince Germany and other members to unleash a quantitative easing (QE) program that includes the purchase of sovereign bonds. The governor of the Bundesbank, Jens Weidmann, has time and again stated that such a move is not necessary. Meanwhile, Chancellor Angela Merkel has aimed her criticisms at France and Italy for those nations’ lack of reforms to boost productivity. French Finance Minister Michel Sapin has in turn publicly scolded Merkel, saying her comments only serve to fuel populism.

U.K. Elections and Anti-Austerity Political Parties in Europe

There is evidence that what Sapin is saying rings true. Greece was one of the hardest hit by the credit crisis in 2008, but before granting it a bailout, the eurozone served up austerity that brought protestors to the streets and fueled the rise of leftist parties. The same pattern is at play in Italy and France where anti-austerity parties or movements continue to fragment power, which could further complicate the already complex quagmire that is the E.U.

Even outside of continental Europe, anti-austerity winds are blowing. The right-wing U.K. Independence Party (UKIP) will add a new wrinkle to the usual two-leading party system in the coming elections. The Labour and Conservative parties cannot ignore the rising anti-E.U. sentiment that has fueled the rise of UKIP, and will add to the debate around stimulus versus austerity that is playing out around the world.

The Ukraine-Russia Energy Crisis That Wasn’t

Energy exporters, especially those where it is the main national export, face an uphill battle after the Organization of the Petroleum Exporting Countries (OPEC) did not orchestrate a cut in production that would have sent the price of oil higher. Ten out of the 12 OPEC members are currently underwater as the price of oil is lower than needed to balance their budgets. Non-OPEC members like Russia — which made energy a negotiation tool with Ukraine — have lost ground as it can hardly afford the West’s sanctions with decreasing revenue for energy exports.

In order to avoid a repeat of past issues with Russia, Europe stockpiled gas to allow for a longer round of negotiations with Moscow. The slower global growth means nations are demanding less energy, while producers maintain the same output, resulting in lower prices. New technologies such as shale oil extraction have also introduced a new source of energy that has put pressure on crude oil prices.

Europe to Face Headwinds Out in the Open

The deadlock in the E.U. parliament will have to be unlocked by Draghi and his peers at the ECB in order to launch a stimulus package. It is the only conceivable path at this juncture that will persuade the markets that the euro won’t keep dropping in 2015. The market remains unconvinced, and until there are signs that Germany is coming around to the idea of sovereign bond-buying, the single currency will remain volatile against the greenback. That makes it harder for investors to predict EUR/USD direction. The Federal Reserve’s impending interest rate hike will mark and end to the low-rate era that resulted after the credit crisis in 2008.

2015 offers European leaders little in terms of a clear path forward. A weaker currency alongside structural reforms could be the recipe for Europe to escape the grip of deflation. Germany is blocking further stimulus measures that would weaken the currency. Italy and France are struggling to pass important reforms. Even if everyone miraculously came together within the contentious E.U., Japan’s fortunes stand as a warning for all. In other words, despite a weakened currency and a QE program pumping out fresh money, there are no guarantees it will turn the tide as intended.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.

Alfonso Esparza

Alfonso Esparza

Senior Currency Analyst at Market Pulse
Alfonso Esparza specializes in macro forex strategies for North American and major currency pairs. Upon joining OANDA in 2007, Alfonso Esparza established the MarketPulseFX blog and he has since written extensively about central banks and global economic and political trends. Alfonso has also worked as a professional currency trader focused on North America and emerging markets. He has been published by The MarketWatch, Reuters, the Wall Street Journal and The Globe and Mail, and he also appears regularly as a guest commentator on networks including Bloomberg and BNN. He holds a finance degree from the Monterrey Institute of Technology and Higher Education (ITESM) and an MBA with a specialization on financial engineering and marketing from the University of Toronto.
Alfonso Esparza