2012 Forecast: Euro to Remain Pressured as Sovereign Debt Crisis Drags Down Economy and Causes ECB to Accelerate Easing

Sovereign debt problems in the Eurozone will continue to dominate financial markets this year. While we believe European finance ministers will eventually resolve the crisis, the situation will probably worsen in the medium-term. The euro, which got hammered in 2011, will remain under pressure in months ahead. In our opinion, high risk premium regarding owning the single currency and ECB's monetary easing are key factors dragging on the currency.

What worries investors the most is the drying-up of the European banking system. Widening of LIBOR-OIS spread and EUR/USD basis swaps has signalled the finding pressures facing European banks. It's also shown that banks in the region are increasingly reliant on the ECB for capital.

Economic condition in the Eurozone deteriorated markedly last year. GDP expanded +0.2% in 3Q11 from a quarter ago. On annual basis, economy grew +1.4%, following a +1.7% gain in the prior quarter. Manufacturing PMI suggested that the sector was in contraction. Meanwhile, dismal business confidence signalled recession is likely this year. At the December ECB meeting, the staff projections suggested downgrades of the economic outlook despite upward revision of inflation forecasts for 2012. We expect the outlook to remain dismal in 2012. Indeed, it's highly likely for the economy of the 17-nation region to fall to recession in the first half of the year. With the economy returning to recession, inflationary pressure will likely ease in the coming months. The ECB forecast that annual inflation will lie between 2.6% and 2.8% in 2011, between 1.5% and 2.5% in 2012.

In December, the ECB lowered the main refinancing rate by -25 bps to 1%. In addition, several new easing measures, including 3-year LTRO, increase in collateral availability and reduction in requirement ratio, were also announced. While liquidity provisions should alleviate tensions in the near-term, expectations of further unconventional monetary measures may lead the euro to take up the status of a funding currency of the year. This will add even more pressure to the euro.