Throttled Trade Gives Euro Bears Even More Reason to Hit Sell

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The euro is at risk of more losses this winter as the region’s manufacturers confront the most challenging environment in decades.

Record-breaking natural gas prices have plunged Europe into a crisis, and business leaders are bracing for the risk of blackouts and energy rationing this winter. In Germany, the cost of imports relative to exports has jumped to levels last seen in the 1980s.

It’s a metric that’s becoming increasingly alarming for euro traders, and now they’re focusing on economic scenarios as they grapple with the effects of the war in Ukraine. Strategists warn that a continued deterioration in the trade balance on further Russian gas supply curbs and surging costs could undermine flows that have supported the currency.

The euro is still trading below dollar parity, even despite growing expectations for the European Central Bank to deliver a 75 basis-point rate hike next week.

“The outlook is dire until prices normalize,” said Kaspar Hense, senior portfolio manager at Bluebay Asset Management LLP. “The theme that purchasing power parity is driving foreign-exchange in the background has not died at all.”

German Economy Gets Another Growth Warning as Trade Volumes Drop

Europe’s energy dependence on Russia is part of an economic model that provided a long-term support to the common currency since its inception. With cash flowing in to purchase products routinely outstripping capital leaving to pay for imports, demand for euros has remained strong. That dynamic is changing.

The theory goes that exchange rates will adjust in line with changes in the current account. Without such supportive flows, a currency can become more “volatile and vulnerable” to changes in external conditions, according to HSBC Holdings Plc analysts.

Goldman Sachs Group Inc strategists see the euro falling to $0.95 in the event of a deeper and more prolonged cut to gas flows. Bluebay, who are short the euro, see the common currency falling “easily” to that level over the coming months.

A prolonged adjustment to the region’s terms-of-trade is not yet in the euro’s price, according to Karen Fishman, strategist at Goldman Sachs. The currency is trading at levels that are in line with the investment bank’s base case scenario of a mild euro-area recession later this year.

Gazprom Won’t Reopen Gas Pipeline in 11th Hour Blow to Europe

While gas reserves are filling up quickly, there’s still the danger of a complete cutoff of Russian supply to the euro-area that could send energy prices to new heights. Such threat of further deterioration in the trade outlook may limit the support that the ECB can provide the currency via more aggressive interest rate hikes, with investors focused on the implications for the region’s growth.

“It’s a highly, highly unusual situation,” said Peter Kinsella, head of FX strategy at Union Bancaire Privee Ubp SA. “The issue is that the eurozone and the European economy is going through a very large macro exogenous shock and one that the euro-zone hasn’t seen, really, ever.”

From a longer-term valuation perspective, the declines in longer-term growth, productivity, and neutral rates for the euro-zone relative to its other regions, suggests that this currency weakness may be justified, according to HSBC. The same goes for the pound, which dropped below the $1.15 level for the first time since March 2020 this week.

“Recent weakness has been aligned with these worsening external accounts,” strategists including Dominic Bunning wrote in a recent note. “This suggests there may be further room for an overshoot to the downside.”

Next Week

The European Central Bank’s policy decision on Thursday headlines next week’s schedule, with a majority of analysts anticipating a three-quarter point hike while money markets place 70% odds on such an outcome
Bank of England policy makers mark a welcome return with a speech due from Catherine Mann as well as testimonies to Parliament by Governor Andrew Bailey, Huw Pill, Silvana Tenreyro
Bond sales including inflation-linked notes are due from Germany and Austria totaling 3.825 billion euros ($3.8 billion). The UK sells bonds maturing in 2025 and 2032 for up to 6.25 billion pounds ($7.22 billion)