Europe is center stage in the week ahead.  It is not as if there are not other important events or economic data due out.  After all, the US reports both the consumer and producer price indices, as does China, along with its reserves, trade, and lending figures. However, for investors, the events in Europe may overshadow them.  

The European Central Bank meeting is the highlight of the week ahead.  Traditionally officials have been wary of pre-committing to a policy change, but this time, they seem to all but promised to move.  And for a good reason.  The recovery has stalled, and a contraction here in Q4 is possible. The pandemic and social restrictions hitting the economy even if less than earlier this year.  

The ECB has one mandate: price stability.  The year-over-year change in the headline CPI has been stuck at minus 0.3% for three consecutive months through November.  It has not been above zero since July. The core rate fares better, barely.  It has been at 0.2% for the past three months and has never been lower.  

The ECB has signaled that while the full range of its policy tools is available, it will focus on two of them.  First, it will expand and extend the Pandemic Emergency Purchase Program.  It had been topped up to 1.35 trillion euros over the summer and extended to the middle of 2021 before the recent surge in the virus.  The market expects the PEPP to be increased by 400-600 bln and for the program to be extended to the end of next year. Some talk circulated ahead of the weekend about the possibility of a longer extension into 2022. Yet this seems to be less relevant to most market participants and may not be needed with the prospects for a vaccine.  Also, the ECB is not committed to using its full PEPP program, which means extending the duration beyond the end of next year may not be a powerful signal.   Second, there is expected to be another offering of long-term loans at quite favorable rates (50 bp less than the minus 50 bp deposit rate or three-year loans at minus 100 bp) provided that certain lending targets are achieved.  

Yet, with the broad outlines largely in the market, the central bank may need to do more to spur a constructive response by investors.  In comments to Reuters last week, ECB Chief Economist Lane suggested there were other dimensions of policy relating to collateral, swaps and repo operations, and the amount of deposits at the ECB that could be exempt from the negative deposit rate.  While officials assure that there is scope to cut the minus 50 bp deposit rate, it seems in no hurry.  

Both the loans and the bond-buying (net maturing issues and loan servicing) add to ECB's balance sheet.  It has risen from nearly 4.7 trillion euros at the end of last year to roughly 6.9 trillion at the end of November.  At the end of 2019, the central bank's balance sheet accounted for almost 39.5% of GDP.  Now it's close to 63.5%.  In comparison, the Federal Reserve's balance sheet has risen from about 19.5% of GDP to 34.5%.  

While there may be benefits to the flexible bond-buying, but it has limits.  The link between the expansion or the size of a central bank's balance sheet, on the one hand, and inflation and exchange rates, on the other, is tenuous at best.  Japan's experience is also consistent with this conclusion.  And at the same time, the low core inflation reading reflects in part the response to the pandemic, such as a temporary cut in the German VAT and bringing forward seasonal sales.  In Japan, the government tried to spur tourism by giving discount vouchers.  

After trading in a $1.16-$1.20 range since mid-July, the euro broke out higher.  The move to new two-year highs near $1.2075 came despite the deflation, the widespread recognition that the ECB will ease policy again on December 10, and the apparent economic divergence between the eurozone, which may be stagnating now if not worse, while the US economy appears to be posting solid even if not spectacular growth.  

Back on September 1, when the dollar first poked above $1.20, there was a flurry of ECB comments, and the euro came off.  Then, like now, we did not expect the break to be sustained.  The ECB comments came as the market was from a technical point ripe for profit-taking.  The technical indicators are stretched, which is not, of course, the same thing as turning lower.  In July, the euro surged about 2.15% on a trade-weighted basis and then moved sideways until testing the $1.20 area on September 1.  Since the end of October, the trade-weighted index has risen almost 2.20%. 

As prognosticators pull update 2021 forecasts, sentiment has swung hard against the dollar, though few match Stephen Roach's call for a 35% appreciation of the euro.  The Bloomberg survey's median forecast for the end of 2021 has crept up to $1.23, and our $1.25 call for mid-2021 is looking too conservative.   

The ECB does not want to be seen defending any particular level.  Nor does the ECB want to signal that it is targeting the exchange rate. Given the importance of the dollar's exchange rate for EMU through trade and financial channels, of course, the ECB monitors it.  And to say that exchange rates influence prices is to belabor the obvious.  Deflationary forces would be less if the euro were weaker, perhaps, but surely it is not so simply linear. Many officials and economists also recognize, for example, that a weaker dollar is often associated with stronger world growth and rising trade.  

Moreover, the current account surplus of more than 2% of GDP this year (2.3% in 2019) still reflects a competitive exchange rate. According to the OECD's Purchasing Power Parity model, the euro is more than 17% undervalued when trading near $1.21, giving it the dubious honor the being the weakest of the major currencies.  According to the OECD, the last time the euro was overvalued was in July 2014, when the euro traded in a two-cent range around $1.35.  A recovery in world demand following the vaccination of massive numbers of people will bolster European net exports and widening the current account surplus next year.  

To be sure, the exchange rate is not the chief economic challenge as the social restrictions are being extended throughout Europe.  The eurozone could be experiencing an economic contraction here in Q4.  Recall the economy contracted by 3.7% in Q1 and 11.8% in Q2 before rebounding by 12.6% in Q3. The composite PMI had been losing momentum since August and fell to 45.3 in November, which was sufficient to drag the three-month average back below the 50 boom/bust level (48.6).  Still, the outlook is brighter, and even with the downward revision, the OECD's new forecasts have the eurozone growing by 3.6% next year (down from 5.1%) and still faster than the US (3.2%  revised from 4.0% ). 

The political challenges that Europe faces seem more formidable. A new trade agreement between the UK and EU remains elusive.  Both sides hope the other blinks first.  Neither side is blinking, but expectations for a deal over the weekend are elevated. Still, the UK is adding a new wrinkle to the plot.  Recall that the government is in the process of passing the Internal Market Bill, which overrides parts of the Withdrawal Bill (divorce decree).  The House of Lords diluted it with amendments that the House of Commons will reject on Monday.  

On Tuesday, the UK will broaden its attack on the Withdrawl Bill that the government negotiated, and the government waged a successful election.  The tax bill that the government will propose gives UK ministers the unilateral authority to determine which goods sent from other parts of Great Britain to Northern Ireland should be subject to tariffs. The UK's damage inflicted by these legislative moves and the attitude it reflects sours the mood and weakens the necessary trust.  

The market, which had strongly leaned in favor of an eventual agreement, is having second thoughts.  The broad dollar decline may conceal what is happening.  Sterling has given back half of the gains scored against the euro over the past three months.  In the options market, the one-month skew (risk-reversal) has surged. In the middle of last week, favor euro calls by nearly 2.4%, twice the 200-day moving average and the highest since the disorderly market in March, before consolidating in the last couple of sessions.    

Lastly, it is important to keep in mind that the transition promises to be chaotic even with a trade agreement.  Places that did not have custom checks and inspection of animal products will now have them.  Necessary documents and registrations multiply.  Even in the best of circumstances, the end of the standstill arrangement will be disruptive and a drag on growth.  

At the same time, next year's EU budget is being stalled. Officials chose to run their joint recovery fund through the EU rather than a eurozone institution and incorporated it into its seven-year budget plan. Some decisions require unanimity, and others a qualified majority. The decision to link the recovery fund to respect for the rule of law was decided by a qualified majority.  However, the overall deal, especially because it calls for joint debt issuance, requires unanimous support.  As much as one recognizes the core significance of the rule of law, doesn't it seem politically naive not to have anticipated Poland and Hungary's dissent, to whom the measures are clearly directed? 

The EU leaders summit on December 10-11 will have to take this up.  One tactic could be to try to split Poland and Hungary apart.  The cost would be great, but it did reach for something that was outside its grasp, like encouraging Ukraine to seek NATO membership.  A deal Poland has hinted it could support is that it drops veto now for 1) not accelerate the emissions reduction target, which falls most heavily on the eastern and central European countries, who more reliant on coal, and 2) preserves the right to sue the EC later over tying the assistance to the rule of law. 

The press reports that the EU would simply proceed without Hungary and Poland in setting up the 750 bln euro recovery fund. While apparently legally possible, it would seem to set a dangerous precedent. It would itself weaken the rule of law by circumventing the spirit that required some unanimity in decision-making in the first place. As the EU has grown, qualified majority voting has increased, but there are still rules, and there are legitimate ways to change them.  This is not one of them, and it runs loose with the sensitivities to the tension between intergovernmental and EU decision-making.  

A fight is brewing over another European initiative. It is trying to reform the European Stabilization Mechanism, its financial assistance arm that loans to eurozone members and can inject new funds into banks.  The reforms strengthen the ESM and its role in backstopping the Single Resolution Fund and spearhead, when and if necessary, the restructuring of government debt.   The issue is splitting the Italy coalition government.  The Five-Star Movement is opposed, pending more progress on other elements of the banking union. The Democratic Party supports the reforms.  The vocal right in Italy, which is in opposition on the federal level, is opposed.  

Prime Minister Conte has offered a compromise where some technical reforms are made, including dropping the so-called single-limb collective action clauses that make it easier to restructure sovereign debt. Conte also wants assurances that sovereign bonds will continue to be regarded as risk-free assets. The Italian parliament will vote on the ESM reforms ahead of the summit. While Conte may carry the Chamber of Deputies, the Senate is more challenging because the majority is small. 

On either a moral grounds or from a realpolitik vantage point, there is no difference between the UK blocking a Brexit deal or France, because national interests are not being served, or Poland and Hungary vetoing the EU budget, or Italy, ESM reform.   Yet, it reflects a governance failure as much as the inability of the US to approve new stimulus despite the Democrats, Republicans, and White House ostensibly favoring more assistance.  Itis a failure of leadership and imagination.  

Given the risk that the eurozone economy is contracting, with inflation below zero for four consecutive months, and the political uncertainty a trade agreement with the UK, a dispute that is risking the EU budget and the 750 bln euro recovery fund, the timing of the upside breakout of the euro from its $1.16-$1.20 trading range since mid-July is a bit surprising.  It is now trading 10-year (120-month) moving average (~$1.2130) for the first time in six years. It broke above the downtrend off the record high in 2008  in July and has been consolidating above it. The broader price action underscores our conviction that the third big dollar rally since the end of Bretton Woods is over.  The prospect of a more durable economic recovery by the middle of next year is also encouraging diversification away from the dollar and dollar assets.  

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