How high will the euro climb?

Since the start of the year, the common currency has jumped from 1.3031 against the US dollar to 1.3670, a gain of +4.9%. And against the pound sterling, the gains are even more pronounced, rising from 0.8131 on January 1st to 0.8641, or +6.27% higher just a month later.

Now, while such rapid rises aren’t unprecedented in my experience, they’re notable, especially given that so very recently the Eurozone was in intensive care.

To explain these gains, without a doubt the biggest factor is the turnaround in euro sentiment. In 2012, the talk was of the currency collapsing. Correspondingly, no one wanted to touch it, leading to outflows to relative havens such as the pound and US dollar.

Now, the risk of a Eurozone collapse has virtually evaporated. So what’s happening is we’re seeing all that capital come out of the UK and US back to the Eurozone, where it would have been in the first place, if not for the debt crisis.

In other words, I’m beginning to think we should look at 2012 as an aberration, whereby the euro was weak because of the extraordinary existential threats it faced. With those threats (seemingly) out of the way, we’re now seeing the euro “correct” to what would be its normal levels.

Given that, the questions we need to be asking ourselves are: What’s the euro’s normal level? How high will the common currency climb? Well, that something we’re going to find out in the coming days and weeks.

In the meantime, there are some things to keep in mind:

British weakness will exacerbate the euro’s rise

You may have noticed that the euro’s gains have been more pronounced against sterling than the US dollar. This reflects the fact that the UK economy still shows practically no signs of life, even as economic indicators elsewhere on the globe pick up.

Most obviously, the UK contracted –0.3% in the last quarter of 2012, putting the UK on a direct course for a triple-dip recession. Add to that the fact that the markets no longer know if the UK will be in the EU in five years time, thanks to David Cameron’s promise of a referendum in 2017, and the pound looks set to be one of this year’s big losers. That will exacerbate the euro’s gains.

For the euro to keep gaining, the Eurozone’s must exit recession

The euro can’t rise on good will forever. If the common currency is to extend its gains, the real economy of the Eurozone will have to pick up. Astonishingly however, there are signs that this might just be about to occur.

The Eurozone’s manufacturing sector contracted at its slowest pace in 11 months in January, hitting 47.9 according to Markit’s latest PMI (figures beneath 50.0 signal contraction, and the lower the figure the deeper the decline.) This tells us that, yes, Eurozone manufacturing is still shrinking, but a turnaround may be coming.

Furthermore, the Eurozone may have arrested its unemployment crisis in December, with unemployment being revised down –0.1% to +11.7%, against forecasts for a +0.1% rise to +11.9%.

Of course, we should caution against reading too much into just one month’s figures. However both these releases are upbeat, and could signal an economic revival that in turn boosts the euro.

The Eurozone still faces political hurdles

It’s not as though Europe is now free from political difficulties. In February alone, the Eurozone faces a number of challenges that could cause this renewed investor confidence to waver and the euro to fall.

This includes negotiations for the 2020 EU budget on February 7th and 8th. It also includes Italy’s general election in February 24th. And, as credit rating agency Moody’s pointed out this week, there’s the constant threat of Greece defaulting on its debts, in spite of all the aid it’s so far received.

In short then, yes, the euro is enjoying a remarkable turnaround at present. We don’t know how far the common currency has yet to climb, especially against a weakened pound sterling. But one thing’s for sure, is that the Eurozone still faces challenges, and these will keep the euro to some extent grounded in the weeks to come.

How high do you think the euro will climb? Is the Eurozone economy set to improve in 2013? Let us know your thoughts in the comments.