For the past two years, foreign exchange (FX) markets have been influenced by the massive global monetary policy stimulus programs and central bank quantitative easing (QE) efforts to stimulate and support local economies. At the forefront of this activity, the Federal Reserve (Fed) aggressively implemented a variety of special measures, including the purchase of $300.0 billion of Treasury bonds and more than $1.3 trillion of U.S. mortgage-backed and agency debt. In Q209, the European Central Bank (ECB) reluctantly joined the Fed and the Bank of England's (BOE) lead by using unconventional measures to help the 16-nation region. As with other global central banks, the ECB's 60.0 billion euro-denominated bond purchase program was intended to improve market liquidity and ease funding conditions.
Trends in 2009
Macro indicators and various surveys suggest that the recession ended over the summer. Investment activity continued to decline in Q209, albeit at a slower pace, but stronger orders for the region and buoyant industrial production over the summer suggests that the inventory cycle will continue to support growth in 2H09. In Q3'09, Euroland officially exited its most severe downturn since the Great Depression, with a 0.4 percent q/q rise in GDP (supported by exports and government spending programs), marking the first positive quarterly growth since Q108.
Among the region's major economies, Germany led the way with growth of 0.7 percent, with Italy not far behind at 0.6 percent. Despite those strong performances, France's recovery has been seen as lackluster at best, and Spain's recession is continuing, led by its anemic real estate market. As a result, Euroland underperformed other G-3 economies during the quarter. At the same time, U.S. GDP rose by 0.9 percent based on initial readings and Japan's recovery accelerated in Q309, with growth of 1.2 percent q/q on stronger exports and investment. Allowing for revisions due to worse-than-expected trade and lower inventories, Euroland was still likely to have grown by around 0.7 percent q/q. Euroland's economy in Q409 is expected to remain on firm footing, driven by the inventory cycle and positive year-end momentum, but consensus for 2010 remains suspect at best.
Outlook for 2010
The 2010 outlook remains subject to a high degree of uncertainty, in particular over how growth will hold up once support from replenishing inventories and government spending fades. Analysis by the ECB suggests that, while government and central bank auctions may have averted some of the worst potential consequences of the financial crisis, there remain significant downside risks to the region's economic outlook.
The global nature of the crisis may limit prospects for a protracted export-led recovery. The unprecedented collapse in exports between Q408 and Q109 imposed a significant drag on Euroland's economy. Exports aside, net trade made a positive contribution to GDP in Q2 (largely because of a continuing contraction in imports rather than a strong revival in exports) and Q3, when export growth picked up. Exports played an important role in the recovery which followed the recession of the 1990s, but this time around, the trade-weighted appreciation of the euro and the sluggish recovery in some key trading partners in the region risk limiting the contribution from export activity.
Any meaningful recovery in the U.S. might not be felt in Europe for many months in 2010. While the Euroland downturn followed the U.S. decline, as in previous cycles, the U.S. and Euroland economic cycles remain highly correlated. The U.S. economy tends to recover quickly after sharp cuts in demand, whereas Euroland countries have in the past had milder downturns and slower rebounds. The peak-to-trough loss in GDP of the current crisis has been worse in Euroland than in the U.S., while the recoveries in both regions have been coincident, although more subdued. The ECB noted recently that "on average, it takes two quarters for a downturn in the U.S. to be transmitted to Euroland, whereas it usually takes six quarters for an upturn to spill over." The current consensus of the U.S. recovery remains somewhat cautious for 2010, with any positive stimulus from the U.S. looking muted at best, especially in the context of the current strong euro.
The risks associated with the financial crisis, the weaker-than-expected economic recovery up to now in Euroland and the strong likelihood that a wide output gap will keep inflation below target for a prolonged period suggest that the ECB will be in no hurry to raise rates. Although it seems likely that the ECB will gradually scale back its very generous liquidity provisions over the course of the year, the expected sluggish economic recovery and below target inflation rate should keep local rates low and the euro contained.