Earlier this month the European Central Bank adjusted its monetary stimulus programme in such a fashion that suggests that any significant gains will be difficult to sustain unless there is a drastic change in sentiment surrounding the strength and direction of the US dollar.

As such we look set to post the third successive annual decline in succession as concerns about the solvency of the Italian banking system, as well as political uncertainty threaten to undermine confidence further as we head into 2017.

So far this year we’ve seen political earthquakes in the UK with the Brexit vote, and the US with the election of Donald Trump as US President, and these unexpected outcomes have raised awareness of the potential for further political disruptions in a Eurozone that is becoming increasingly dysfunctional as politicians battle with their own populist problems.

While the problems with Greece are well documented they certainly haven’t gone away and unemployment still remains eye wateringly high here, while EU finance ministers continue to show little in the way of flexibility in trying to convince the IMF that they should remain involved with the next part of any new bailout plan.

The problem continues to be around the issue of debt sustainability, a major sticking point for EU leaders; however it is becomingly increasingly clear that without it Greece’s economy will continue to struggle.

Over the last 12 months trust in the EU has fallen sharply in the face of a weak recovery and dysfunctional political leadership, along with a reluctance to accept that the cohesiveness of the entire euro project is now increasingly at risk.

The continued tired repetition of “more Europe” is unlikely to restore confidence and merely reinforces the view that European political leaders are completely out of touch with the concerns of their local populace.

The problem of Italian banks continues to erode trust in Italian politics as well as in the overall economy, as officials struggle to recapitalise a banking sector that is weighed down by €360bn of non-performing loans.

While officials in Italy struggle to restore confidence in the banking system, the rebound in commodity prices along with higher inflation expectations has seen Italian borrowing costs start to rise sharply in the last two months, with 10 year yields recently doubling to over 2% since the beginning of October.

This presents a big problem given that between February and June next year Italy will have to roll over €270bn, which wouldn’t be a problem but for the fact that Italy’s debt to GDP ratio is already over 135% of GDP.

Add in the potential for an upset in Dutch, French and German elections next year as populist discontent continues to grow and you have a cocktail of uncertainty that is likely to weigh on potential inward investment into the euro area.

Twelve months ago there was a great deal of speculation about the prospect of the euro falling through parity against the US dollar; however this was based on the premise that the Federal Reserve would probably raise rates at least three to four times in 2016, while the ECB would find it difficult to ease policy that much more.

This always seemed an unlikely outcome despite market expectations that we’d see at least three rate rises, and something that we warned of at the time.

The weak inflationary outlook a year ago always made the prospect of any more than one rate rise unlikely given the 22% rise in the US dollar over the period from the end of 2013 to the end of 2015.

Since the end of 2015 we’ve seen the greenback gain another 3% on top of that, with most of that coming since the US election, on expectations of a significant fiscal stimulus.  

This year could well be different given that unlike twelve months ago inflation pressures are showing signs of increasing which could well change the calculus with respect to US monetary policy.

Furthermore 10 year yield differentials between bunds and treasuries currently favouring the US dollar are higher than they were in the year 2000, when the euro made its all-time low at 0.8230, and much wider than they were a year ago, when the difference was 130 basis points in favour of the US dollar.

Source: Bloomberg

Now they are close to 222 basis points and back at levels last seen in 1989 On the two year measure the gap is narrower, but still at levels last seen in the year 2000.

The recent lows from 2015 currently sit at 1.0460, however in the past month or so the euro has broken a key long term support line which suggests that unless we are able to push back through 1.0800 then a test of parity could only be a matter of time.

Source: CMC Markets

With the euro now on course to post its third annual decline in a row albeit a modest one the sideways price action of the last twelve months could well see a break out in the coming weeks and months.

In terms of policy while the prospect of further easing from the ECB seems somewhat remote due to the constraints surrounding the current policy, particularly in an election year for Germany, and the start of the taper program in April, they still won’t be tightening policy any time soon.

On the other hand in US policy could pan out differently dependant on how the Federal Reserve reacts to a Trump Presidency.

For now the FOMC is suggesting we could get three hikes next year after finally pulling the trigger on their second rate rise since the financial crisis.

While it is never wise to take these dot plot projections at face value, quite frankly they’ve been a lousy guide to what the Fed has actually done in the past few years; they do nonetheless paint a picture of how US policymakers see the US economy.

It is important to note they pay no regard to how external events can and do influence Fed policy, which means we may only get one rate rise next year as well, especially if events in Europe take a turn for the worst politically.

Next year’s FOMC committee is likely to be of a more hawkish nature with three new regional Fed Presidents being able to vote for the first time. At least one of these members, Patrick Harker of the Philadelphia Fed has suggested that an immediate rise in rates is necessary, and that the case for further rises would increase in the event of a significant fiscal stimulus.

As we head into 2017 it seems likely that the euro could well be about to have a crack through its floor of the last two years and revisit levels around parity last seen at the end of 2002, as the policy divergence between the ECB and the US Federal Reserve continues to widen.

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The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person