This website uses cookies. We use cookies to ensure that we give you the best experience on our website. Read More
Divided EU members during the pandemic cast a shadow on the old continent

Divided EU members during the pandemic cast a shadow on the old continent

2 Apr 2020 01:44 PM

The COVID-19 pandemic outbreak is the biggest crisis the old continent has had to face since Hitler started the second world war.  The human and economic toll has reached levels that were unimaginable just a few weeks ago. Yet while the euro hasn’t done particularly well during these devastating times, it is far from being the worst performer. Nevertheless, does the current euro exchange rate reflect traders’ confidence in the European Union’s handling of the outbreak or was it undervalued to begin with?

Carry trades unwinding

To begin with, the euro surged against the US dollar when the virus breakout started and intensified in mid-February, forcing many analysts to wonder if the greenback had lost its safe haven status. But it soon became apparent that the moves were driven by the unwinding of carry trades as expectations that the Fed would soon cut interest rates to zero sparked asset reallocation outside the US. Currency carry trade occurs when people borrow in one currency and invest in another country.

Up until recently, the euro had been a desirable currency for carry traders as they borrowed cheaply in the Eurozone where rates are negative, to buy higher yielding assets such as US stocks and treasuries. However, after the Fed’s emergency rate cuts, the dollar lost its yield advantage and outflows were to be expected.

Liquidity rush knocked the euro down

Between mid-February and 1 March, the euro-dollar pair reached the 1.15 mark due to carry trades, but fell after the Fed rate cut announcement. Soon after soaring to a 13-month high of $1.1492, the euro took a tumble, plunging to a 3-year trough of $1.06 as market panic intensified and the virus triggered dollar shortages amid a sudden rush for cash. With these one-off flows having settled down, it’s back to fundamentals for the euro/dollar.

But where does the euro go from here? The Eurozone economy entered this crisis at a time when economic growth was already weakening, while the US economy was in a good shape. Nevertheless, US policy makers have set up a much bigger fiscal package relative to their growth domestic product compared to their EU counterparts. On the monetary policy front too, the Fed has gone much further than the European Central Bank by pledging unlimited bond purchases.

Technically there is one way to go, a bearish setup

For the single currency there is apparently only one way to go, and it appears to be down, as it would be very hard to imagine it jumping back from its long-term downtrend. However, with the dollar’s relative interest rate advantage being wiped out and a cheap euro, the scope for further downside in the euro/dollar may not be as considerable as it used to be. The initial drop happened at the start of 2018 when US yields were paying much more than the euro, but that’s no longer the case.

This is on the assumption that markets behave in a normal manner and the Eurozone’s current trade account surplus and the safety of German government “bunds” can limit an aggressive selloff such as that experienced by the pound recently. But given that the markets are in panic mode and there are potentially more losses to come in stock markets, the prospect of another bullish dollar wave remains high, and that probably is the biggest risk for the euro in the present environment.

Should a liquidity rush towards the US dollar strike again, the euro could soon be re-entering March lows of $1.06. A breach of the $1.07 would make the pair vulnerable towards the January 2017 $1.03. The euro/dollar is more likely to seek a bottom nearer the $1.08 level if there is an absence of any further intensification in market stress. It would also be susceptible to upside moves.

Divided members make things harder

The latest fiscal measures announced by Eurozone countries to date are currently in the range of 1-2% of GDP. They are tiny compared to the US stimulus plan of 6% of GDP. However, there are high hopes that EU support could soon be made available to member states as Eurozone policy makers are mooting to release additional funds by using the European Stability Mechanism (ESM).

What would be surprising is if the Euro group agree on mutualised debt issuance. The idea of issuing euro-denominated common bonds to share the debt burden has been around since the last 2008 financial crisis. However, this was rejected many times during the Eurozone debt crisis and continues to be opposed by Germany and the Netherlands which are considered fiscally conservative countries.

Whatever form EU aid takes, any additional scope of spending for paralysed European economies would go a long way to ease their pain through the crisis. This in turn could put the euro back within the $1.12-$1.14 range in the short term. In the longer run however, the euro dollar pair performance will depend mostly on the success of existing policies and the speed of recovery relative to the US.

Tags:

Prices may be delayed by 5 seconds. Prices above are subject to our website terms and conditions. Prices are indicative only