Brexit, US recovery could spell doom for euro’s rally against US dollar
- With the threat of a no-deal Brexit looming and the European Central Bank moving towards another monetary policy ease, the euro is living on borrowed time
- A US interest rate rise is likely while euro zone rates are in negative territory, so shorting the euro and going long on dollars could gain a strong following
The euro has had a good run against the US dollar in 2020, but the rally appears to have reached the end of the road. The dollar seems a better bet with the US Federal Reserve stonewalling on negative interest rates, US growth prospects looking more upbeat, and markets focused on a Joe Biden victory in the US presidential election in a fortnight’s time.
Global economic recovery is shakier than some would suggest
Europe’s three largest economies – Germany, France and Italy – are all in recession, and an expected recovery in the second half of 2020 would stall if economic confidence takes another turn for the worse. Europe is vulnerable after GDP growth contracted by 2.5 per cent year on year in the first quarter of this year, followed by a 14.1 per cent collapse in the second quarter. The pressure remains for European monetary and fiscal policy to stay highly accommodative for a long while yet.
Europe’s confidence indicators are bouncing back, but the big issue is whether recovery is sustainable. Europe’s bellwether economic sentiment indicator rallied from an all-time low of 63.8 in April to 90.2 in September, an encouraging sign for recovery but only as long as there are no further setbacks.
Europe could go into a deeper stall, unemployment could rise sharply and the ECB would need to compensate with deeper rate cuts and more quantitative easing, adding pressure on the euro.
It is not just the economic fallout currency investors need to worry about, as the consequences for European political unity could be just as damaging. Europe has presented a relatively united front throughout the Brexit negotiations. Once Britain quits, the usual political frictions risk resurfacing, especially over funding Europe’s growing budget gap and the EU’s recent disputes with Italy, Poland and Hungary.
Pressure for a softer euro will only intensify as European governments look to stronger export-led growth to provide an extra boost to recovery. The weak economy, super-loose ECB policies, political strains and potential benign currency neglect could wreak major damage on euro sentiment.
China is a land of opportunity for EU firms willing to adapt
With the US economy expected to grow between 3.5 and 4.5 per cent next year, the odds of a 2021 Fed rate increase look much more likely. With euro zone interest rates already in negative territory, shorting the euro and going long on the dollar could attract a strong following. The euro exodus could quickly turn into a rout, with the currency dropping as much as 10 per cent in the next year.
Long-term euro investors and large currency reserve managers such as China need to make quick decisions on whether to ride out the storm or to hedge against potential downside risks. The only real alternative for Beijing is to diversify more of its euro reserve holdings into US dollars.
David Brown is the chief executive of New View Economics
