Collapse of the Euro More a Case of Eurozone Weakness Rather than US Strength

At the start of the year, all the focus was on the European Central Bank but in early March that has started to shift back to the Fed.

The ending of the Fed's zero interest rate policy is nearing reality as we approach mid-year, and the repercussions are most prominently being played out in the foreign exchange markets with the rise of the US dollar, especially against the euro.

At one point last week, the euro sank to a 12-year low against the dollar; strikingly, the German bund yield curve entered into negative territory all the way out to the 20-year sector.

The triggers for the sudden move are threefold.

• First, February's strong US payrolls report confirmed the strong trend of job creation in the US economy that is likely to lift wage Inflation, although it has been lagging.
• Second, the European Central Bank started its quantitative easing programme, which cast the spectre of Fed tightening and US policy divergence with the rest of the world as a near-term reality.
• Third, expectations are growing that the Fed Will remove the word "patience", in reference to keeping monetary policy accommodative,  at this week's monetary policy meeting.

The collapse of the euro is probably more a case of eurozone weakness rather than US strength.

US growth is moderate relative to previous recovery cycles (real GOP is forecast at 2.8% this year); it is certainly not going gangbusters but is exceeding the eurozone, which is expected to grow 1 .7% this year. Furthermore, the US twin deficit issue has not gone away.

The US current account deficit was 2.3% of GDP in 2014 and is expected to remain around that level this year and next. In contrast, and suggesting that all is not lost for the euro, the eurozone had a current account surplus of 2.4% in 2014 and is forecast to rise to 3.2% this year.

However, as policy divergence widens, the US dollar is 1n the unusual position of being able to act as the world's shock absorber as the eurozone and Japan addresses their structural economic fragilities. On a trade-weighted basis, valuations are not yet at extreme levels.

Between 2002 and 2008 the US dollar depreciated nearly 40%, largely due to the US' need to finance the significant current account deficit.

Competitive devaluations are having unforeseen consequences across economies and asset classes.

We are already seeing the profitability of some of the larger US-based global corporates being undermined. The UK IS also not immune.

Last week, Mark Carney, Governor of the Bank of England, expressed his concern about "the protracted effects of sterling strength" on consumer prices and its potential impact in delay1ng the Bank of England's rate tightening cycle.

However, the most vulnerable areas may be emerging markets (EM) and commodities, which are priced in US dollars. Emerging currencies have been so far resilient in the latest dollar surge.

Those currencies that have weakened (the Brazilian real, Turkish lira and South African rand) are probably responding to idiosyncratic country factors, as much as the general trend of US dollar strength.

Compared with the past, EM sovereign external debt (based in US dollar) has been substantially reduced as EM fundamentals improved.

But the worry is the EM private sector: US-dollar based debt to EM non-financial corporates is at its highest level s1nce the late 1990s (as a percentage of GOP).

The fixed income markets have been the principal provider of EM corporate liquidity since 2009.

If corporates are unable to service their debt obligations, liquidity is likely to dry up and that will create a lot more volatility across the fixed income asset class more generally.

Historically, the Fed has come to the rescue of EM by cutting rates.

However, the Fed has little room for manoeuvre given where current rates are and where the Fed appears to be heading. It has a careful task this week in managing its message to the markets.