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Euroboom: Why Economic Growth is What Really Counts for the Euro Now

European Union

The implications for the strengthening Eurozone economy on the Pound-to-Euro exchange rate are likely to be profound.

A wave of economic growth in the Eurozone is supporting a sudden rise in the single currency versus its major counterparts, which analysts are saying is sustainable.

The Euro is rising on the back of better data and a more optimistic outlook for growth in continental Europe; November 14 saw Eurostat confirm Eurozone GDP rose 0.6% in the third quarter, marking an impressive 2.5% growth in activity on the same period last year.

"Essentially we are witnessing potentially the best macro-economic recovery since the Euro came into existence and certainly the best since we experienced the constant existential risks throughout much of the period since the Great Financial Crisis," says Derek Halpenny at MUFG.

The Euro exchange rate complex rose sharply on the news helping ensure the single-currency is the best-performing G10 currency of the week.

The Euro-to-Pound exchange rate is up 1.40% over the course of the past week; one Euro buying 89.67 pence at the time of writing compared to only 88.96 on Monday night.

This gives us a Pound-to-Euro exchange rate at 1.1151; its lowest level since October 20.

The strength of the Euro has seen the single currency move back up above 1.17 versus the Dollar, with a Euro now purchasing 1.1815 US Dollars compared to only 1.1570 last week.

What has caused this surge in the Euro and is likely to last?

Halpenny argues that fundamental economic growth is what matters for the Euro now and the outlook suggest more might come on the back of better-than-expected growth data for the third quarter and more upbeat official forecasts from the European Commission.

"The Euro is the undisputed FX king in the G10 space... it is the top performer so far this week, and it was given another push higher after decent GDP data for Q3," says City Index Market Analyst Kathleen Brooks.

Stronger economic growth boosts a currency by increasing the attractiveness of that region to foreign investors.

"The euro area economy is still capable of upside surprises, despite many months of strong momentum. Importantly, as well as showing strong German investment growth, the data also point to a continued positive contribution from net exports. This type of backdrop provides a strong base for EUR strength," says Shahab Jalinoos at Credit Suisse.

A region which is booming will attract more inflows of capital to fund projects or purchase assets, due to the enhanced prospects of investors turning a profit from those investments.

The increased inflows of capital raise demand for the host currency - in this case, the Euro - which increases in value.  

More directly, growth also tends to raise inflation, which leads to central banks having to raise interest rates to combat the inflation and markets are betting that the European Central Bank will not only have to stop printing money, but it will also have to start raising interest rates within the next two years.

Higher interest rates are a major positive driver for a currency too because they also attract increased inflows of foreign capital due to the draw of higher interest returns.

That is why the rise in growth in the Eurozone is good for the Euro.

One of the most startling features of the most recent Eurozone data is that it shows growth to be evenly spread amongst member states, with the usual top performers such as Germany standing side-by-side - for a change - with so-called laggards, such as Italy.

"Interestingly, Germany and Italy, two ends of the Eurozone growth spectrum, managed to post above-consensus growth figures for the three months ending in September, with German GDP rising by a decent 2.8% and Italian GDP rising by an equally impressive 1.8%, above the UK’s paltry rate of 1.5% for last quarter," adds Brooks.

Will Growth and the Euro continue rising?

The Euro's long-term prospects are of course tied to the prospects for economic growth in the region.

Most analysts see growth in the Eurozone in 2017 of 2.3%, but they tend to be more cautious about 2018, seeing it dip to 1.9%.

The main reason for the fall, it has been suggested, is that the strengthening Euro itself will become a headwind to further growth.

The reason this is so is that one of the main drivers for growth in the region is exports, and a stronger Euro will make Eurozone exports more expensive and therefore less competitive argues UBS Economist Reinhard Cluse.

Falling exports are expected to place a -0.4% drag on growth in 2018 according to Cluse reducing it from 2.3% to 1.9%.

The view is supported by Julius Baer Chief Currency Strategist David Kohl, who also sees headwinds from a stronger Euro in 2018:

"Next year, Eurozone growth will remain solid as well but should decelerate slightly to 2%. The European Commission expects growth to follow the same trajectory (forecasted at 1.9%). The major reasons are the lagged effects from a stronger euro exchange rate on growth and slowing growth dynamics in China," says Kohl.

Not all analysts agree about the rising Euro being a headwind to growth - Unicredit Economist Dr. Thomas Strobel, for example, sees growth continuing to accelerate in Germany, one of the region's key exporters, regardless of the appreciating Euro.

"The downside risk to industrial activity, as it originates from a stronger Euro, seems to have become manageable and is unlikely to threaten the industrial recovery," says Strobel.  

"Moreover, with capacity utilisation in the manufacturing sector remaining above its long-term average and business sentiment indicators at historically elevated levels, we expect the ongoing recovery in global trade to benefit German companies, outweighing headwinds from FX markets," adds the economist.

Gains for the Euro vs. US Dollar Ahead

MUFG expressed a view earlier this year not long after EUR/USD broke above the 1.1500 level for the first time (18th July) that a new trading range of 1.1500-1.2500 might have been established.

"The correction higher from the recent low of 1.1554 (7th November) has increased our confidence in that view," says Halpenny.

Implications for the Euro vs. Sterling Outlook

The implications for the strengthening Eurozone economy on the Pound-to-Euro exchange rate are likely to be profound.

Currently, growth in the UK is undershooting that of the Eurozone, with Q3 comparisons showing UK growth rising by 1.5% to Germany's 2.8% and even below Italy's 1.8%.

If the trend continues, as it is widely expected to, then the British Pound will probably fall versus the Euro, with a recent note from Swiss private investment bank J Safra Sarasin, expecting divergent growth to push EUR/GBP up to 0.95.

This gives a GBP/EUR target down at 1.0500.

J Safra Sarasin are pessimistic about growth in the UK over the next few years; inflation will remain high due to a weak Pound keeping imports expensive, and this inflation will erode real wages.

Lower real take-home pay will result in less consumption and falling growth ensuring the Bank of England will have its hands tied when it comes to raising interest rates. At present markets expect two more interest rates at the Bank of England over the course of the next two years, but should this become less-likely, then the Pound could come under notable pressure.

"Our latest forecasts show the British economy to decelerate from 1.5% GDP growth in 2017 to 1.3% in 2018 and 1.2% in 2019," says Adolfo Laurenti, Global Economist at J Safra Sarasin.    

For the Pound, it ultimately all comes down to the 'B' word

One significant unknown variable in the Pound's story is of course Brexit.

A good deal could boost the Pound and help alleviate the negative effects of high inflation while boosting corporate investment, thus boosting economic growth once more.

Sarasin's Laurenti confirms that outcome of Brexit presents a great unknown when it comes to forecasting the Pound's direction against the Euro:

"Of course, the forecast is at best an educated guess, as the process toward Brexit remains mired in both known and unknown unknowns. Final outcomes will rest on, crucially, what model of partnership will be established between the EU and Britain."  

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