Q4 could prove to be a rough ride for EUR
As soon as fear starts taking a grip in global markets, the weaknesses of the Eurozone along with its deep structural flaws soon gets highlighted and Q4 could be particularly tough for the EUR.
Growing deflationary pressures and weak demand are likely to have been exacerbated by the stress tests of the Eurozone's banks with the results due early next week. Passing those tests means many banks have been curbing lending to build up regulatory capital.
Nonetheless, the exercise may have already done some damage to credit availability to the economy and continue to undermine the EUR over Q4. So far fears in the global markets have been soothed by noises from the US Federal Reserve that it won’t rush to raise US interest rates. That has helped the EUR. But fears could easily bubble up again on poor economic data.
The European Central Bank is trying to counter those pressures. It is buying covered bonds, will soon add asset backed securities and offer four-year loans to banks – all in a bid to shove vast quantities of liquidity into the system to revive lending.
Still heading towards QE
If it turns out that the Eurozone's banks are actually in good shape, then the bulk of the work beefing up balance sheets may be over and a stronger banking system would certainly be welcome. However, it may still not be enough to spur a revival in lending by Europe's banks, despite the ECB's best efforts, as demand remains fundamentally weak.
This is due to a range of factors including the slowdown in China's economy, lack of economic reform in the Eurozone, austerity programmes and ageing populations. Should inflation numbers start to turn negative and growth continues to fall then the ECB will steadily come under pressure to do something 'spectacular' with the EUR likely to sink and yields on peripheral Eurozone debt potentially exploding
Another factor is that since the financial crisis regulatory reforms are forcing banks to become much more risk adverse in their lending policies. Simply put, they may not find that many suitable opportunities to advance credit, despite the ECB's liquidity.
German politics permitting, that could set the stage for full-on quantitative easing, i.e. buying government bonds in secondary markets, which has been used by the other major central banks. Such a move, if large enough, would probably lift global equity and commodity markets and could even, ironically, boost the EUR as existential questions are once again put to rest.
However, QE would likely only provide a temporary boost to the Eurozone economy and sentiment. Fundamentally, it suffers from deep economic weaknesses, which the ECB can't address. It can only buy time for policy makers to make reforms. So far that only tends to occur under the duress of crises.
By Justin Pugsley, Markets Analyst MahiFX