Euro: The greatest policy divide in 20 years is mostly in the price

The euro is ending 2015 down about 12%, which is one of its largest annual losses since its launch in 1999 but less remarkable underperformance in a year when a dozen currencies have depreciated by more. Relative to those, all of which are in the EM and commodity blocs, the euro has had the advantages of above-trend growth and a current account surplus, which mostly explain why the currency maintained a 1.05-1.15 range from March to November.  Every good range deserves to be broken, however. 

The forecast profile for 2016 (Q1 1.05, Q2 1.03, Q3 1.08 and Q4 1.13) shows the euro breaking the bottom of that channel in the first half of the year, and then threatening the topside in Q4 if the Fed pauses and ECB tapers. This tame view may sound odd ahead of the greatest US-European monetary policy divide since 1994, when the Fed tightened at a record pace while the Bundes bank eased. But the euro has not always declined when Fed hikes boosted the trade-weighted dollar - the currency actually rose during the 1986 and 1994 Fed cycles.  

More important for the upcoming cycle are three concerns: substantial Fed-ECB policy divergence is already discounted in the euro's current level; the Fed tightening cycle might be too shallow to offset Europe's current account surplus; and German Bunds could deliver another VaR shock given rich valuations and almost record-long investor positions. Avoid again this year the temptations of broad euro-funded carry just because the ECB in easing. Fundamentals in highyield currencies remain poor and vol shocks likely.  

Risks to the view: On the downside, more aggressive Fed tightening, an upsizing of ECB QE to €80bn per month and an adverse outcome to Spanish elections. On the upside, ECB unwillingness to ease much, the Fed inability to hike more that twice or a step-up in equity capital/FDI flows into Europe given valuations.