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5 reasons why the Eurodollar may continue to fall



5 reasons why the Eurodollar may continue to fall

THe following article was written by Giles Coghlan, Chief Currency Analyst at HYCM.


The Eurodollar pair has been under a great deal of pressure so far in 2020. Up to now, we’ve seen it crashing through last September’s support to trade at levels last seen in 2017. This has caused some commentators to speculate as to whether the Euro could continue to drop against the greenback, perhaps even going as far as reaching parity.

It appears Europe is currently being assailed by a myriad of factors both internal and geopolitical. Many are part of the legacy of the ECB’s “whatever it takes” approach to save the Euro in the wake of the last crisis.

Some factors, like Brexit and the rise of nationalism among its member states, are deeply rooted in the very history of the union itself. Other factors, like global slowdown, the fallout from Trump’s trade war and now coronavirus, see the EU taking collateral damage while already in a weakened state. Below we’ll examine five reasons why further weakness could be in store and why all but the most aggressive Eurodollar traders may want to take pause before buying dips.

1. The Euro Carry Trade

Carry trades involve borrowing a currency with a low-interest rate and using it to purchase another currency with a higher interest rate. It’s essentially an interest rate arbitrage that becomes even more attractive when currency volatility is low and there’s an interest rate difference that traders expect to continue. These are the precise factors that have converged to make the Euro carry trade such an attractive bet for investors of late.

At the tail end of 2019 FX volatility hit record lows, causing currency traders to pile into carry trades due to reduced opportunities elsewhere in FX markets. Volatility may have ticked up a touch off these lows, however, the expectation is that it’s set to continue in 2020. The Euro remains a particularly attractive funding currency for carry traders due to its 0% interest rate. Also, with the US maintaining its own rates at 1.75%, you can see why there’s currently such a bias towards dollar strength and Euro weakness.

Of course, carry strategies are vulnerable to interest rate shocks, but it also doesn’t look like the ECB is going to be able to generate the kind of inflation that would necessitate a rate hike in the near term. Fiscal stimulus could produce the desired effect, but we’re still a way off from coordinated EU-wide spending of the kind would lead to a change in interest rate policy.

Recent Euro declines are also likely to exacerbate the selling pressure on the single currency by increasing the profitability of existing shorts. This can have a feedback effect which can lead to further downside risks.

2. German Weakness

Europe’s engine room has been showing signs of stalling for a while now and its non-existent fourth quarter growth hasn’t helped matters in the slightest. The German economy sputtered in Q4 of 2019, with preliminary GDP readings having come in at 0%. It narrowly avoided going into recession for the year, with a meagre GDP growth rate of 0.6% compared to the US GDP of 2.1%. While this weakness can be attributed to the usual culprits such as slowing global growth and the trade war, Germany’s woes seem to be more far-reaching than just these headlines.

As a traditionally conservative nation, Germany has been slow to adapt to burgeoning technologies such as electric vehicles, autonomous driving, and 5G. If these are to play a major role in the future, one has to wonder whether Germany’s wait and see approach will leave it playing catch-up as other nations like China and the US take the lead. As a major industrial incumbent, particularly in the automotive industry, Germany has a substantial infrastructure geared up to mass-producing internal combustion engines. This infrastructure will have to be renewed if it is to play a central role in the coming EV revolution.

On the political front, as Chancellor Merkel’s 14-year stint draws to a close, and with her successor of choice, Annegret Kramp-Karrenbauer, having recently resigned, holes appear to be emerging in the traditionally strong German political centre. Germany has thus far managed to avoid the populism that has been brewing elsewhere in Europe, but is it just a matter of time? A Germany that’s weakening economically at the same time as being in political disarray can only spell further pain for the Euro going forward.

3. No Longer a Safe Haven

It’s quite clear that the Euro is not currently behaving like a safe-haven currency. One of the first indications we received that this relationship was beginning to break down was at the beginning of 2018 when US stock markets slumped. Many at the time were expecting the Euro to receive a bid as investors became fearful, however, this bid failed to materialise. By December of the same year, when US equities took an even greater tumble, the Euro was trading almost 9% down from where it had been in February.

Europe’s industry remains much more sensitive to trade stresses and weakening global demand than the US, leaving it vulnerable to all the current geopolitical factors that are said to be weighing on growth. This is having the knock-on effect of further unravelling its currency’s safe-haven status. Its recent drop against the Swiss Franc to levels last seen half a decade ago, testify to the fact that the market no longer regards the Euro as a safe place to turn to in times of uncertainty.

3. Coronavirus Fears Persist

Europe’s vulnerability to coronavirus is not merely to the resulting economic fallout. It’s well known that the EU is highly exposed to Chinese demand as China is one of Germany’s most important export partners.

However, the EU is also likely to be more vulnerable to the spread of the virus itself. This is due to having much looser borders than countries such as the United States.

The market is currently discounting the risks of this latest pandemic. Should this prove to be a mistake Europe’s structure as a political and economic union of otherwise diverse nations means that it cannot hope to coordinate the type of effective centralised response that a single country with firm borders can mount. Recent reported outbreaks in northern Italy are a case in point and an indication that we are not out of the woods yet.

5. Trump Tariffs

Europe’s weakening currency, record-low interest rates and resumption of quantitative easing are likely to continue attracting the ire of the US commander-in-chief. President Trump has been vocal about what he regards as a “big currency manipulation game” by both China and the EU. He has frequently bemoaned the relative strength of the US dollar and has recently stated that the EU is “impossible” to trade with, going as far as saying that the EU is “more difficult to do business with than China.” With US-China trade tensions looking as though they may be cooling down, it’s possible that Trump will now turn his attention to the EU.

His administration recently announced that it would be increasing import tariffs on EU aircraft from 10% to 15% in March. The original 10% tariff was imposed in October after the World Trade Organisation ruled that the EU had been illegally subsidising Airbus and allowed the United States to impose tariffs amounting to €6.9 billion. Since then the US has also hit the EU with a 25% tariff on other products originating from the region including wine, coffee, cheese, and olives. This could be the shape of things to come, at least for as long as Trump remains in office. Such a move could weaken the Euro even further and have the opposite of Trump’s desired effect.

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5 reasons why the Eurodollar may continue to fall

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