'Stars Align' for the Euro

"The stars have aligned for EUR but where do we go from here?" - Valentin Marinov, Crédit Agricole.

The foreign exchange analysis team at Crédit Agricole believe more strength in the single-currency should ensure the Pound-to-Euro exchange rate remains under pressure and means a break above 1.13 is unlikely, for now at least.

The call comes after the Euro strengthened in value in the wake of the release of the European Central Bank's December meeting minutes and the momentum has seen the currency touch a fresh three-year high against the US Dollar. The Pound-to-Euro exchange rate is meanwhile seen being held close to the bottom of a range that has been in place since October 2017.

The minutes proved a boon for the Euro right across the board after they showed ECB policy-setters expect Eurozone's robust economic performance to continue over the coming year.

Released on Friday, January 12 the minutes confirmed wage dynamics in the Eurozone were improving and this suggested to markets that the intent to withdraw stimulus at the ECB over coming months remained intact. Recall, it was the belief that the period of extraordinary stimulus at the ECB was reaching its end-point which made the Euro one of the best-performing global currencies in 2017.

"The December ECB minutes that were perceived as moderately hawkish as well as mounting evidence that the Eurozone recovery has broadened and deepened. In addition, renewed market concerns about reserve diversification away from USD have highlighted that global central bank are still underweight EUR," adds Valentin Marinov, Head of G10 FX Strategy with Crédit Agricole in London.

Analysts have also attributed much of the strength as lying with news German politicians are finally coming close to agreeing on a ruling coalition that will put Angela Merkel back in power.

"There is a symphony of factors that work in Euro’s favour at the moment. These range from euro-area-specific influences – such as positive political developments (see Germany), a more-hawkish-than-expected ECB, exceptionally strong regional economic data and ongoing undervaluation," adds Dr. Vasileios Gkionakis, Co-Head of Strategy Research & Head of FX Strategy Research at UniCredit Bank in London.

The Euro Can Go Higher Against the Pound

But what of the outlook, is the Euro's strong run likely to run out of steam at any point?

Not necessarily, say a number of analysts we follow, including Crédit Agricole who confirm to clients this week that they remain bullish on the Euro in coming months because they expect the political risks in the Eurozone will finally start abating on a more sustained basis after the March election in Italy.

We note that the prospects of Italy proving to be a fundamental threat to the future of the Eurozone and European Union have abated somewhat with a number of key Italian politicians coming out in favour of membership of both unions of late.

Former Prime Minister Silvio Berlusconi - who is widely tipped to stage an impressive comeback - has said in a radio interview that leaving the single currency would hurt Italy’s economy and added that his main ally, the eurosceptic Northern League, now shared his view. However, risks have not completely dissipated as the Northern League have confirmed they will seek to exit the Eurozone should they win.

Nevertheless, currency strategists believe this to be a relatively remote outcome which should allow the ECB to exit their money-printing programme and consider raising interest rates once more.

"We expect the ECB to continue to taper its asset purchases and, ultimately, stop expanding its balance sheet into the year-end against the backdrop of continuing Eurozone economic recovery," says Marinov.

But a stronger Euro will have another important engine driving it argue Crédit Agricole; global reserve managers will continue to invest money in EUR-denominated assets in coming months and quarters in order to profit on improved performance in the Eurozone.

As such, Marinov advocates chasing the Euro higher, particularly against the Pound.

"We believe that EUR/GBP may offer interesting buying opportunities ahead of the UK inflation and especially retail sales data release for December due later this week," says Marinov. While inflation data went by without incident, most agree that it is Friday's retail sales data that will give the more important snapshot of the UK economy at the start of the new year.

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Risks to the pro-Euro View

While clearly being bullish on the Euro's prospects based on views concerning Italy, the ECB and global reserve managers, Marinov concedes that each positive factor has the potential for providing disappointment and downside for Euro bulls.

For one, concerns may grow at the European Central Bank that the EUR has moved too far too quickly for comfort.

"Indeed, a potential continuation of the latest aggressive FX moves and the associated tightening in the Eurozone financial conditions will not go unnoticed at the Governing Council," says Marinov, referring to the all-important council of European central bankers that decide on policy at the ECB.

The analyst therefore believes caution is warranted ahead of the ECB meeting on January 25 where President Draghi could try once again to talk down the currency.

It is also note that the risk of a minority M5S government in Italy ahead of the March 4 election has seemingly increased, "all that could suggest that investors may opt to take profit on long-EUR positions before long."

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Inflation Data Marginally Supportive

Pound Sterling's solid run was granted an extension after UK inflation read at 3.0% in the month of December, a shade softer than November's 3.1%, but in line with analyst forecasts.

When data meets analyst expectations it tends to have a neutral impact on Sterling which ensures recent trends remain in place.

Thus we are seeing the Pound-to-Dollar exchange rate trade near 18-month highs at 1.3767 and the Pound-to-Euro exchange rate hold its daily gains at 1.1255.

The ONS reports the downward effect to UK prices came mainly from air fares, along with a fall in the prices of a range of recreational goods, particularly games and toys.

The downward contributions were partially offset by an increase in tobacco prices, reflecting duty increases that came into effect following the Autumn Budget, along with an increase in petrol and diesel prices.

"The fall-back in CPI inflation from 3.1% in November to 3% in December marks the beginning of what we expect will be a sustained downward trend over the course of this year," says Paul Hollingsworth, Senior UK Economist with Capital Economics in London.

Whatever the case, news that price rises might have peaked will be welcome news to consumers who have seen their pay rises outstripped by rises in prices over recent months. Indeed, should inflation continue to fall in 2018 then the standing of the consumer will likely improve, particularly if wages increase as widely expected.