By Global FX Strategy, Jordan Rochester
- We’ve been running short EUR/USD positions since early April when EUR traded above 1.08, and added the most recent spot position on 9 June at 1.0661. It’s been over a 6% move lower in EUR/USD since we added, 8% since April and 12% year to date. We expect another 5% towards 0.95 by end-August but lower our conviction today to 8/10 (from 9.5). It may soon become a risk to the trade that Russia turns on Nord Stream 1 flows back on after the maintenance period, and if so we may see some short-term EUR relief rally, to then be faded.
- If Russian Nord Stream 1 gas flows are not restarted (high risk) — we believe Europe may fail to build up sufficient gas storage for the winter and this may lead to energy rationing. The Bundesbank estimates a potential 5% hit to GDP in such a scenario for Germany. We doubt the market has yet to fully price in this scenario. Even if Nord Stream 1 flows resume, Germany’s ZEW points to a recession to come and our Economics team from Q3 2022 forecasts four consecutive quarters of negative growth. However, the main point for flows is that the EU’s aim is to fill gas storage over the summer at whatever price. This is leading to mechanical forced buying of LNG (from the US, Azerbaijan, Qatar and others) and is probably the key reason why EUR/USD has fallen this fast. Europe’s gas storage levels are at 62% (target 80%). If the pipeline flows continue at 40% capacity or stop completely, Europe will only be able to refill storage to 69% and 60%, respectively
- EUR/USD is following 2yr rate spreads and the ECB curve is yet to invert like the US. We have largely been using the collapse in the euro area’s terms of trade to make the big calls on direction. However, EUR/USD is also closely correlated with 2yr swap spreads. If the first two rate hikes materialise (July, September) recession fears in Europe are likely to pick up, and we may see the ECB curve invert like it has already done in the US after just a few rate hikes in its cycle. That alone would see EUR lower.
- Euro area manufacturing needs a weaker EUR to remain competitive — the terms of trade suggest 0.65: There are two factors weighing on the competitiveness of euro area manufacturing: 1) losing significant access to Russia and Ukrainian supply chains leads to higher import costs from other sources; and 2) energy costs in Europe are multiples higher than in the US (natural gas prices are 6-7x higher than the US and climbing). Demand is also another factor — China’s COVID-19 business cycle has led to a slowdown in exports from the EU to China. The collapse in the euro area’s terms of trade ratio to that of the US suggests a fall in EUR/USD to 0.65 or so.
Russia turns on the gas flows: With the return of the gas turbine from Canada Russia may have lost its easy excuse used to drop Nord Stream 1 gas flows. However, Russia has also identified five turbines in need of repair and may simply point to faults in the others to justify a low or no return of flows after the scheduled maintenance period ends (11-21 July). If the flows restart at just 40% of capacity we would expect the rally in EUR to be brief as it still leads to Europe potentially running out of gas in the winter. But if Nord Stream 1 restarts at full capacity we’d expect a short-term big move higher in EUR as short positions would be reduced. Hence, our slightly lower conviction in short EUR/USD of 8/10. Economic stimulus or a shift in central banks: The focus will be on what the “ECB can do” despite having few credible tools to resolve the supply-side problems. A dovish Fed could provide what is needed, but that’s unlikely for now. The ECB may talk up the possibility of 75bp rate hikes in October and December – but this would likely simply weigh on European asset prices even more – and it’s not clear whether it would boost the euro area if German factories are offline. With the EUR approaching early millennium levels we may get some comments on FX intervention (joint FX intervention was used to help support EUR in its early years), but it is unlikely as most central banks are in the same position.
See FX Insights – Strategy portfolio update for our past trades