The euro has surged over 9% against the dollar since mid-May, when Angela Merkel and Emmanuel Macron first signaled a desire for a joint response to the pandemic-driven recession.
Since then, a faster-than-expected agreement on the rescue plan (although with caveats), strong forward guidance by the ECB, and the gradual de-escalation of containment measures have driven the euro’s appreciation to multi-year highs. Compared to its G10 peers against the dollar over the last three months, the euro ranks in the middle of the currency board. According to CFTC data, euro net long positioning among non-commercial market participants has reached a historic high.
Chart 1. EURUSD has recently rallied to multi-year highs while net long positioning is at an all-time record
The euro rally has partly been a result of broad dollar weakness, as US real yields sharply fell and the Covid situation in the US worsened towards the end of Q2 compared to the reopening seen in Europe. In addition, hopes that Europe will lead both the pandemic management and economic recovery was a main driver for the recent EURUSD rally and bullish positioning. With interest rates at effective lower bounds in the G10 space, differentials in economic recoveries has been a key driver for FX markets.
However, while it seems reasonable to assume that European governments will deliver a combined pandemic management and fiscal response that will compare well to the US, we still believe there are reasons for maintaining caution over our optimistic euro outlook.
The following table shows our EURUSD forecasts for the coming year, while the rest of this outlook discusses the views informing them. These estimates are slightly more bullish than current consensus, but we note that many institutional forecasts are being revised upwards after the surprising euro appreciation seen in recent months.
COMPETENT VIRUS MANAGEMENT IN THE EUROZONE LESSENS MACRO RISKS
While swift and aggressive containment measures imposed across the continent proved effective, allowing the economic recovery to begin at an earlier time, new infections have gained momentum in local hotspots in Spain, Germany and France. These localised outbreaks pose risks of further containment measures and, therefore, downside risks for both the trajectory of the European recovery and European asset prices. With select travel bans already in place and some restrictions to the tourism and leisure sector already implemented across the region – especially in Spain -, prospects of a sharp economic recovery are in question. Moreover, there is significant uncertainty on how much appetite there is for further fiscal support in the face of a second wave of the pandemic, especially at a supranational EU level.
The rampant euro and outperforming European stocks have arguably already priced in a relatively faster recovery path from the pandemic-driven recession than the US´s. The imposition of further lockdown measures will therefore add downside risks to previous pricing. However, key features of recent outbreaks in the area have somewhat eased concerns about a potential re-imposition of stringent lockdown measures.
On net, we believe the EU is likely to avoid further broad and extended lockdowns of the sort seen in March and April, although the situation is fluid.
The panel below broadly describes the current situation. Even though the overall rate of infections has increased across the region as containment measures are eased (2a), a stable count of fatalities (2b) along with lower hospitalizations put less stress on the health care system, thus providing ample room to maneuver before severe containment measures are needed. Also, the pattern of recent outbreaks is geographically concentrated and the systems for tracking new infection cases have improved. Finally, the relatively controlled nature of case growth at present has meant softer control measures such as mandatory facemask wearing, local lockdowns and restrictions to certain contact-intensive services, are being used. These are less harmful to the economy compared to the previous general lockdowns (2c). Altogether, these arguments lead us to expect a milder impact of the pandemic in the eurozone economy, whereas the Covid situation in the US paints a relatively uglier picture (hyperlink to the USD outlook).
Chart 2. Current Covid-19 situation in major eurozone economies
2a. Number of daily Covid cases relative to the closure of non-essential businesses
2b. Number of daily Covid deaths relative to the closure of non-essential businesses
Source: World Health Organization
2c. Current containment measures in major Eurozone economies are less stringent compared to their peers.
However, downside risks to our optimistic view of the Eurozone’s relatively better prospects abound. Even though the daily infections are still alarming in the US, the lower level of testing in major European countries might be misrepresenting the actual Covid situation in the area. While testing policies in the US are open to the public, including the asymptomatic, testing in most European countries are limited to people with symptoms only, potentially underestimating the overall rate of contagion. Statistically, the current positive test rate data in the US is subject to a 2.11% margin of error compared to 2.87%, 3.13% and 4.77% in France, Germany and Spain respectively.
This highlights the greater amount of uncertainty over the European statistics, which could be underreporting the true situation.
If this argument were to prove correct, not only would the European success in fighting the virus be under question, but the apparent gap with the US would be narrower. This is particularly relevant in the face of the current surge in cases, as a worse-than-expected second wave of infections could weight on the euro outlook.
Chart 3. Contagion gap between the US and EU might be narrower than data shows
UNPRECEDENTED SUPPORT TO AN UNPRECEDENTED CRISIS
Beyond the relatively controlled pandemic situation, bullish euro moves have gained momentum from policy stimulus introduced by European institutions. The combination of an explicitly accommodative monetary policy stance with the approval of the joint recovery fund has provided the eurozone with unprecedented support to face its deepest peacetime recession. Market optimism on European assets is heavily underpinned by this strong policy support. Spreads between national public debt yields – a key sign of political and economic risks in the area- are the narrowest since the pandemic outbreak in March, while yield curves have partly flattened despite lingering risks to a V-shape recovery. European equities have outpaced their US peers, which is remarkable considering the sharp euro appreciation of recent months –a historic driver of pain in export-orientated European stocks.
Current market trends are similar to those during the financial crisis a decade ago, when gaps between US and euro-area yields shrank and the euro rallied over the coming year.
With markets increasingly expecting the Fed to strengthen its forward guidance on the back of a bleak economic outlook, prospects of relative monetary policy stability in the eurozone are likely to drive further currency strength, in our view. Consensus forecasts compiled by Bloomberg point to a 5.5% GDP expansion for the eurozone in 2021, about 1.5 percentage points faster than the US´s. However, the accuracy of this forecast is anybody´s guess, as much of the economic recovery depends on the unknown evolution of the pandemic. The strength of the nascent labour market recovery in the US also presents a downside risk to this view, casting some doubt about how much lower US real yields will fall, and the prospects of a fundamentally weaker dollar in the medium- and longer-run.
Chart 4. A closing gap between US and European bond yields are supportive of a strong euro narrative
While the short-term prospects of the recovery might be driving currency optimism, the sharp euro rally points to a more structural increase in confidence among investors in the euro area. One could argue that even though the EU recovery fund is relatively limited in size – around 5% of EU GDP – it is unprecedented in the history of EU fiscal policy.
The 750 billion emergency fund is the first joint debt issuance by the European Union as a bloc, which is a major first step towards necessary fiscal integration in the area.
Its significance goes beyond simply lowering long-term funding costs for recovery financing, as the securities will be a supplement to German bunds as a safe asset in European debt markets. Ultimately, the landmark deal sooths concerns over the bloc´s structural risks of collapse and is likely to support other European assets from idiosyncratic default risks.
However, despite the significance of the recovery plan and joint debt issuance, relying on this to drive further strength in the euro in isolation would be mistaken. There are several limitations embedded in the plan.
- The mutualised debt program is conceived as a one-off package designed to overcome the current crisis. This means that the path to a structural fiscal integration in Europe is still years away and not assured to become a reality, even with this precedent in place.
- Even if the initiative sets a major precedent for joint response mechanisms to future crises, strong political opposition by fiscally conservative states poses big challenges. As such, resources from the recovery fund will come with conditions attached, including a requirement to undertake economic reforms. While structural changes may be conducive to productivity gains in the long-run, they might also pose barriers to growth in the short-run.
- Projects are subject to oversight by a qualified majority of EU governments in order to avoid misuse or fraud. Excessive scrutiny could delay spending and trigger further political disputes, rendering the recovery fund less effective.
- Higher rebates to net contributors of the common budget, a necessary compromise to bring them aboard, also pose constraints to future funding.
- The conflict and disagreement over the recovery plan may mean that the bloc will be hesitant to use fiscal policy as a further marginal stimulus during the slower parts of the recovery, similar to that seen during the “lost decade” of the 2010. Put simply, the recovery plan may dig the region out of the current crisis, but the following recovery may end up being lackluster due a resumption in tight fiscal policy.
- Without the so-called cross default clauses – the mechanism binding individual member states to repayments in the event of default by the European Commission, the high-quality status of the joint debt is vulnerable to future political crisis.
When critically assessed, these arguments pose considerable downside risks to potential EU growth and fundamental euro appreciation. They also limit the appeal of the new European debt instrument as an alternative safe-haven to US treasuries or Japanese government bonds. BIS data shows that the global use of euros for international transactions and as reserve of value hasn´t varied significantly with respect to the USD or the JPY after the recovery fund was proposed, although these reconfigurations can take some time.
POSITIVE CURRENCY OUTLOOK MUST BE CAVEATED BY NEGATIVE BALANCE OF RISKS
We believe the single currency is still set to build on its recent surge against the dollar as the greenback also retreats against its major peers. The euro should continue to benefit from a narrower yield differential with the US, as markets price in prospects of lower-for-longer interest rates and flat yield curves. Whether or not the eurozone is poised to lead the economic recovery remains to be seen as currently available hard data and macro leading indicators might be subject to varying conditions depending on the development of the pandemic. Scarring to the labour market has been deep and heterogeneous across eurozone countries, but somewhat milder when compared to the likely more persistent damage in the US. Stronger schemes of unemployment benefits and legal enforcement to employers across Europe also underpin the resilience of the labour market amid the current recessionary environment.
Ultimately, the single currency is likely to attract increasing attention from investors as unprecedented fiscal support, combined with a broadly accommodative monetary policy, sets the base for a sharp recovery path.
Unlike the 2010s, no sovereign debt crisis is currently looming as a downside risk, as low rates globally lead investors to be more tolerant of fiscal deficits.
However, the rapid surge of the single currency to date leaves a lower bar for negative surprises and consequently, a downside correction. Risks to a rallying euro over the medium-term are plentiful and include:
- Markets might be wrongly pricing in the lagging speed of the US economic recovery, while the assumed quicker resumption of the EU economy remains highly uncertain under the prospects of constrained fiscal support in the future. The uncertain evolution of the pandemic poses challenges to a relatively faster economic recovery, as do drawbacks embedded in the recovery fund. Possible constraints to further fiscal expansion in the EU may be a barrier to structurally higher growth. By contrast, the US has ample degrees of freedom to run larger budget deficits and should US growth surprise significantly to the upside, this could potentially subvert our current expectations for a weaker dollar.
- Upcoming US elections present ambiguous risks over the EURUSD outlook. As markets start to price in a potential Biden win, a weaker dollar may arise on the back of a more predictable approach towards China and improved risk sentiment worldwide. On the contrary, a Biden victory could develop broad dollar demand as prospects of a better pandemic management and a faster domestic recovery could build up. Moreover, increasingly underpriced odds of a Trump re-election could trigger a sharp repricing in financial markets.
- Continued euro strength, if sustained over a relevant period, might not pass unnoticed by the ECB. A stronger currency limits an important channel of monetary policy transmission, dampening domestic growth prospects via a highly exposed exports sector. Even though the ECB explicitly rules out the exchange rate as a policy target, the central bank could discourage further currency strength by ad-hoc vocal action, akin to that seen recently by the RBNZ.
- Another potential risk to our current view is related to the unknown effects of a potential vaccine by year-end and broad distribution in early 2021. The larger marginal effect of a treatment on a relatively worse US Covid situation could trigger a sharp repricing of growth expectations in the US with respect to Europe, resulting in a game changer to the apparent European lead and to bullish euro expectations.
- The renewed pressure on the Turkish lira – which has lost a fifth of its value against the euro this year-, raises alarm of a potential banking crisis filtering to the eurozone. Even though European banks have reduced their exposure to lira volatility since the 2018 currency crisis, Spanish and French banks are still the largest foreign lenders to Turkish entities. A weaker lira also dampens exports demand to the European Union, with Turkey being the sixth-largest exports market of European goods.