Why the euro is undergoing a “fundamental adjustment”

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A Euro currency symbol is displayed in the visitor center of the European Central Bank (ECB) building in Frankfurt, Germany.

Alex Klaus | Bloomberg | Getty Images

In the past month, with the comeback of Covid-19, the European Central Bank policy divergence and political uncertainty converging, the euro fell sharply.

As of Tuesday morning, the euro fell 2.6% against the US dollar this month, fell 7.8% year-to-date, and weakened against other major currencies.

Germany, the Netherlands and Austria last week re-implemented strict Covid-19 containment measures during the fourth wave of infections across the European continent, renewing concerns about the euro zone’s growth recovery.

At the same time, the European Central Bank has maintained its dovish stance despite soaring inflation, and other central banks have indicated that interest rate hikes may slow down.

European Central Bank President Christina Lagarde said last week that the bank “does not rush to tighten prematurely when facing past or supply-driven inflation shocks.”

The euro rose slightly on Tuesday after the Eurozone Purchasing Managers Index in November showed an unexpected rebound in business activity, which once again hinted that the European Central Bank may tighten policy before the end of 2022.

Goldman Sachs co-head of foreign exchange strategy Zach Pandl said in a report on Friday that the recent weakness of the euro against the dollar can be largely attributable to the expected change in Fed policy because the economic situation is better than expected.U.S. October Inflation Report

“To some extent, these risks now seem to have been digested: the comments made by Fed Governor Waller and Vice Chairman Clarida on Friday that the Federal Open Market Committee may accelerate the pace of quantitative easing have limited impact on the euro/dollar. “He added.

The U.S. dollar index, which measures the U.S. dollar against a basket of major currencies, hit its highest level since July 2020 on Monday. But Pandel said that certain European factors, such as the new activity restrictions in mainland economies and the dovish attitude of the European Central Bank, may explain the euro’s weakness against the broader currency cross.

Goldman Sachs holds short positions in the euro against Swedish krona, Polish zloty and Czech koruna. Shorting a currency indicates that the trader believes that it will depreciate relative to the other side of the currency pair over a period of time.

The trade balance is neglected

BMO Capital Markets emphasized in its latest foreign exchange position analysis that leveraged funds have been cutting long bets on the US dollar in various currencies. As of Monday, the US dollar index has appreciated by 7.2% year-to-date. closure.

However, the euro-dollar cross is one of the few that saw an increase in US dollar bulls in the week ending November 16. The net short position of EUR/USD increased from USD 5.1 billion in the previous week to USD 5.7 billion, while the direct EUR short position increased by nearly 11,000 contracts with a total value of USD 14.3 billion.

“Our view is that the euro is undergoing a fundamental adjustment, which is not only related to expectations of policy differences between the European Central Bank and other central banks, new COVID-19 restrictions in some EU member states, and moderate to high political risks,” BMO Europe Stephen Gallo, head of foreign exchange strategy, said in a research report on Monday.

“Although these factors are important, we have listed the deterioration of the Eurozone trade balance in the third quarter as one of the most important drivers of euro weakness, which continued to weigh on the euro in the fourth quarter.”

Gallo emphasized that as of Friday’s close, the narrow measure of the nominal value of the euro — its unadjusted weighted average relative to other major currencies — fell by 1.2% in the third quarter and has fallen further so far in the fourth quarter. 2.5%.

According to data from Eurostat, in August 2021, the Eurozone’s merchandise trade surplus with the rest of the world was 4.8 billion euros, while in August 2020 it was 14 billion euros. In September 2021, the total trade surplus narrowed from 24.1 billion euros to 7.3 billion euros in the same month of 2020.

“A separate but interrelated issue is that the euro also needs to embed a mid-term’energy security risk discount’ in the price,” Gallo said.

“In the short term, the downward oil price will become a buffer below the euro, but we believe that a large number of negative fundamentals may mask the positive impact of the decline in oil prices.”

Although some of the cyclical factors affecting net trade may fade in the next two years, Gallo believes that structural changes involving “de-globalization” forces and efforts to achieve carbon neutrality mean that the euro area’s export growth may not be the same. As positive as it used to be in the past two decades.

“Looking forward to the end of the year, the position of the euro against the dollar may dampen downside momentum,” Gallo concluded.

“We will also point out that the extent of the Fed’s rate hike has been reflected in the USD curve in 2023. This is a potential upside risk for the euro against the U.S. dollar. If anything will cause these rate hikes to be cancelled.”

BMO’s current one- to three-month range for the euro is estimated at $1.11-1.16.

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