Euro to Remain Heavy Until German Economic Clouds Clear as Growth Currently on Life Support

Commerzbank HQ looms over the Frankfurt skyline. Image © Andre Douque, reproduced under CC licensing conditions

- EUR treads water as dire German data comes thick and fast.

- German economy still on life support amid multiple headwinds.

- ECB downgrades and a lacklustre EUR performance lie ahead.

The Euro was left treading water Friday after a series of statistics showed the German economy on life support early in the New Year while inflation data confirmed that Eurozone consumer price pressures are going nowhere fast, which is a twin headache for the European Central Bank (ECB).

Europe's largest economy hit a rough patch last year and is yet to extricate itself from it, while some economists say things could get a lot worse before they get better. The upshot is that this and other headwinds are expected to continue weighing on the single currency for a while yet.

"Reeling from a series of external shocks, Germany’s export-orientated economy fell into stagnation in H2 2018. Leading indicators project more weakness ahead. Further external shocks could even cause a recession," says Holger Schmieding, chief economist at Germany's Berenberg. "The downturn has spread beyond exports."

Germany's Institute for Economic Research (Ifo) sentiment index fell to 98.5 during February, from 99.3 previously, when markets had looked for it to level off at 99. Companies grew more pessimistic about their current situation in February, as well as the outlook for business conditions over the next six months.

The Ifo survey polls 9,000 German companies in the manufacturing, services, trade and construction sectors, asking them to give their assessment of the current business situation and their business expectations for the next six months.

The index itself represents an average of responses about the current situation and outlook, with a base year of 2005. It is regarded by financial markets as Germany's most influential measure of business sentiment.

"The IFO is crystal clear in its sombre message. Whatever happened in the second half of last year got worse in Q1, and is now threatening to push the German economy over the edge," says Claus Vistesen, chief Eurozone economist at Pantheon Macroeconomics. "The IFO is still keeping EZ economists up at night."

Both Schmieding and Vistesen say Germany's economy is well positioned to weather any global economic downturn due to sound household and public finances. But they also say they are concerned that regulatory, political and international trade headwinds are driving the country's mighty industrial sector into the ground.

The downturn among manufacturing companies is now threatening to drag the economy below the waterline, as businesses are being disrupted by the U.S. trade war with China, uncertainty over the final outcome of the Brexit saga and a number of other headwinds. 

New regulations governing the testing of emissions outputs from new cars hurt output from the industrial sector last year although companies remained relatively positive in their outlook. Now, with the trade war and Brexit endgames approaching, and European parliament elections looming in May, companies are growing fearful for the outlook too. 

"As businesses scale back their expectations for the future, investment growth will slow in early 2019. Households already reacted to rising uncertainty by raising their savings rate in H2 2018. It will take some easing of trade tensions, better news out of China and an end of the hard Brexit risk to end the downturn. We expect these three conditions to be met at some time this spring. Until then, German data can continue to disappoint," says Schmieding. 

The Euro-to-Dollar rate was quoted -0.01% lower at 1.1341 during the morning session Friday and is now down a little over 1% for the 2019 year-to-date, although the Euro-to-Pound rate was 0.17% higher at 0.8710 but has fallen more than -3% this year. 

"The ECB is in a tough spot and so is the EUR.  The ECB’s next steps are either going to be credit- & risk asset-supportive or they’re not, and both outcomes should exert a braking force on EUR strength.  Our preference is still to play EURUSD from the short side," says Stephen Gallo, European head of FX strategy at BMO Capital Markets.

The Ifo survey followed hard on the heels of official data confirming the German economy slowed to halt in the final quarter of 2018, with GDP growth of 0%, after already having contracted -0.2% during the previous three months. 

It also came ahead of inflation data that confirmed the Eurozone consumer price index fell to 1.4% during February, down from 1.6% previously, and that core inflation picked up only from 1% to 1.1%. It's the core inflation rate that is most important for the European Central Bank policy outlook.

"This was mainly thanks to a 0.1pp downward revision of non-energy goods inflation. Indeed, as far as we can, non-energy goods inflation has been revised down significantly, further raising questions about whether the ECB can ever get the core rate to 2%," says Pantheon's Vistesen. "We think the core rate will edge higher in the next six-to-12 months, but it won’t get anywhere near the ECB’s target. Indeed, we expect the central bank to downgrade its inflation forecasts, again, in March."

All of Friday's data matters for the Euro because of what it might mean for the European Central Bank interest rate outlook. The ECB needs core inflation to reach its target of "close to but below 2%", and in order to get there it needs a robust Eurozone economic expansion. 

Neither of those things are happening currently and increasing numbers of economists are giving up hope of seeing the inflation target met any time soon. The ECB has already acknowledged risks are now tilted to the downside and hinted strongly in January that it may be 2020 before the bank is able to lift its interest rate from current record low levels.

"We continue to take the view that the ECB’s forecasts for core inflation are too high. The current quarter is likely to be the fourth successive one of sub-trend growth. There is still slack in the labour market, which should dampen wage growth. Low inflation expectations will also work in this direction," says Nick Kounis of ABN Amro. 

Kounis and the ABN team say the ECB will hold its interest rates at current levels until December 2020 and that it will soon provide a new programme of cheap loans for the Eurozone's banks in the hope of stimulating an economic recovery and consequent pick up in inflation. 

ECB chief Mario Draghi will deliver a speech at the University of Bologna at 15:30 London time on Friday, which markets will listen to closely for clues on how the bank's outlook for the bloc and monetary policy is evolving.

The ECB's main interest rate is still at 0% and its deposit rate is at -0.4%, meaning it costs banks to deposit money at the ECB rather than paying them. But the ECB ended its multi-year quantitative easing programme in December and previously stopped the targeted-long-term-refinancing-operations (TLTRO) that provided cheap cash to banks.

"Given internal data disappointments and downside risks to the outlook including Brexit and upcoming elections, euro strength looks to be further in the future and less material than previously thought," says Bipan Rai, a macro strategist at CIBC Capital Markets. 

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