The Euro will continue to weaken

EURUSD is trading on historic lows of almost a decade after breaking the psychological level of 1.20. It may be only the starting point of a deeper and prolonged depreciation of the euro toward 1.15.

The two key elements explaining the recent EURUSD drop are the revival of the sovereign debt crisis and the anticipation of the ECB launching an easing program to avoid a Japanese-style deflation in the euro area.

Once again, the ECB will have no other choice than to take the lead in order to reassure investors. That means implementing a sovereign bonds purchasing program despite German reluctance. It may not be the best option to strengthen growth and reinforce inflation, but it is the only option left.

The ECB may launch this program as soon as January 22nd. Over the past few weeks, pressure has increased on the central bank after the publication of data confirming the increasing risk of deflation in the Eurozone. For the first time since 2009, year-on-year inflation turned negative, as measured by the December Euro Zone CPI estimate, with much of the pressure coming from the 30% plunge in the oil price since OPEC’s last meeting in November.

The question is not to know whether the QE will happen but what size the program will be and which assets will be purchased. Will Greek and Cyprus bonds be part of it? How long will the operation last? There are plenty of unsolved issues!

Nowadays, monetary policy is playing with fire. We don’t know all the long-term outcomes of the accommodative measures yet. However, it is certain that it won’t make the structures of economy more efficient in the Eurozone or provide any durable solution to the issues fiscal deficits and public debt.

The picture is not entirely gloomy. Many European countries may benefit from the decrease of the euro by improving price competitiveness. But it won’t be enough. The Eurozone cannot win the global race to the bottom in currencies. It is a never-ending battle. To overcome the crisis, the euro area should tackle key pending issues regarding product competitiveness, wealth transfers from rich countries to the periphery and closer fiscal union.

It will appear very fast that expectations about the macroeconomic impact of the QE are far too optimistic and that monetary policy is not able to replace governments’ actions. Poor economic performance and risk of exit from monetary union may cause investors to lose confidence in the euro. Being short EURUSD has been a profitable and very popular trade. More downside movement is probably coming over the next few months, as it will become more obvious that the euro area is unable to get back on the right track.