The Euro-zone economy contracted at a record pace in the first quarter, and the plunge in German GDP was simply breath-taking. In our view, the Euro-zone economy will continue to contract through at least the third quarter, which should lead to euro depreciation against the dollar.

Record Decline in GDP in First Quarter

Data released this morning showed that real GDP in the Euro-zone plunged at an annualized rate of 9.7 percent in the first quarter relative to the previous quarter (see top chart). Not only was the decline a record (the overall Euro-zone series starts in 1995), but it was also sharper than most analysts had expected. On an individual basis, every major country in the 16-member Euro-zone reported a sizeable decline in real GDP.

Germany is the largest single economy in the Euro-zone-it accounts for roughly one-third of the region's GDP-and the contraction in its economy was simply breath-taking. As shown in the middle chart, real GDP dropped 14.4 percent in the first quarter. Relative to the first quarter of 2008, the German economy is nearly 7 percent smaller at present. A breakdown of real GDP into its underlying demand components is not yet available, but German authorities indicated that weakness in capital spending and exports were the culprits for the sharp contraction in the economy. Germany is an important supplier of capital goods to many Eastern European countries, and the economic meltdown in that part of the world has imparted a sizeable negative shock to the German economy. Moreover, net exports have been an important contributor to German GDP growth over the past few years. Now that the global economy is in a deep recession a major driver of German economic growth has evaporated.

Relative to Germany, the contraction in the French economy in the first quarter was not bad at all. As shown in the bottom chart, real GDP in France fell only 5.2 percent in the first quarter. France is not nearly as exposed to exports, not only to Eastern Europe but overall as well, as is Germany. In addition, monthly data suggest that consumer spending in the first quarter held up better in France than it did in Germany.

Data from the second quarter are rather scant at present but it appears that economic activity in the Euro-zone continues to contract, albeit at a slower rate than in the first quarter. For example, purchasing managers' indices for the manufacturing and service sectors remain in contraction territory through April. In our view, economic growth in the Euro-zone will remain negative on a sequential basis through at least the third quarter. European policymakers have done less to stimulate their economy than their counterparts on the other side of the Atlantic Ocean. In addition, the ECB has reduced its main policy rate to only 1.00 percent (the Fed has cut the fed funds rate to less than 0.25 percent), and the ECB is just starting to dip its toe into the pool of unconventional monetary policy measures. Because we believe the upturn will be slower coming to the Euro-zone than to the United States, we look for the euro to trend lower vis-à-vis the dollar over the course of 2009.