Euro to Hit New Lows in Early 2019 but Recover Lost Ground into Year-end says BMO Capital Markets

© European Central Bank

- EUR to weaken in Q1 2019 as EU election approaches say BMO.

- But will recover soon after, before ECB lifts rates in final quarter.

- Although view is subject to ECB inflation forecasts being borne out.

The Euro slipped lower Thursday after the European Central Bank (ECB) sounded a cautious tone at its latest policy press conference, but strategists at BMO Capital Markets say better days are up ahead.

Mario Draghi, President of the ECB, told markets Thursday that the Eurozone economic outlook has deteriorated in recent months and that risks to growth are now firmly to the downside. 

For the time being at least, the ECB has stuck to its commitment to begin lifting interest rates next year, which is important because it is the core of BMO's idea about the single currency. 

Stephen Gallo, European head of currency strategy at the bank, says any move by the ECB to lift its interest rates from record low and negative levels will enable the Euro to recover ground ceded to a resurgent Dollar in 2019. 

However, the single currency will first need to survive the European parliamentary election in May, and that election must also not produce a resul that brings the future of the political project into doubt. 

"We think the balance of economic and geopolitical risks favours a move in EURUSD to 1.09 in 3M. Amidst a slowing growth outlook and Brexit-related tension, the Eurozone is beset with deep-seated political fragmentation which should come to a head in the May 2019 European parliamentary elections," Gallo writes, in a note to clients Thursday.

He says once the election risk is cleared, the Euro could rebound to 1.12 before the end of June and ultimately finish the year at 1.22, so long as the ECB does actually go ahead and begin lifting its interest rate in the final quarter.

The latest guidance is that rates will rise once "through the summer of 2019" and the quantitative easing programme will end this month. However, the rate rise is contingent on its economic forecasts being borne out in reality.

"We expect the ECB to nudge its key interest rates gently higher in late-2019 and we look for the broad value of the USD to turn lower, driving EURUSD to 1.22 at the 12M horizon," Gallo writes.

The ECB says the economy will grow by 1.7% next year, down from the 1.8% projection issued in October. Eurozone growth was 2.3% in 2017 and is now forecast to come in at 1.9% for the current year.

The growth outlook has been dented of late by a range of factors including new regulations in the automotive sector and the effect President Donald Trump's"trade war" could have on export-dependent countries like Germany.

Eurozone growth fell from 0.4% in the second quarter to 0.2% in the third this year, while German GDP growth fell to -0.2% in the same period, its first contraction since 2015.

Inflation is forecast to decline to 1.8% for 2019 as a whole, down from 2% in November. It has risen above the target of "close to but below 2%" this year thanks largely to previous increases in the oil price.

However, what matters most for the ECB policy outlook is the core inflation rate, which refers to the consumer price pressures left over after energy and food items are removed from the goods basket, and has actually fallen this year.

Core Eurozone inflation fell from 1.1% to 1% in November. That is exactly the level it was at in January 2018 and is only 10 basis points, or 0.1%, above the level it was at in January 2017.

As a result, the European Central Bank has not made any real progress toward its inflation target, in underlying terms at least, over the last two years.

"Markets price in an extremely dovish ECB, but Draghi departs in 11 months and his replacement is unlikely to be so dovish. There is already a strong clamour for a northern ECB president," Gallo says, countering the ECB's detractors.

The Euro-to-Dollar rate was quoted 0.08% lower at 1.1362 Thursday and is down -5.2% for the year, while Euro-to-Pound rate was -0.28% lower at 0.8982 and has risen 1.58% this year.

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