EUR: Bracing for a break below parity
EUR/USD is trading 30 pips above parity at the time of writing, having reached a 1.0006 low yesterday. The question now is whether the pair can find some support and stage at least a mini-rebound, or break below parity. If we look at the global economic picture, we believe the second option remains more likely, and even if we think that a return to 1.0500 in the autumn is still a tangible possibility, a short-lived dip to 0.9800-0.9900 in the coming days looks relatively likely.
The factors that hold the keys to the short-term outlook for EUR/USD are well known now: the risk of a fully-fledged energy crisis in Europe if Russia curbs gas supply, the consequent worsening outlook for the region’s growth, a potential dovish re-pricing of European Central Bank rate expectations and – above all – the adverse global risk environment. Our impression is that the worst scenario for each of these factors has not been priced in yet, and given the pressure applied by the bullish USD environment, downside risks persist.
As discussed a few days ago in our article “FX: What happens when EUR/USD breaks parity?”, given the importance of 1.0000 as a psychological level in EUR/USD, we suspect that a break lower could force a technical drop by one standard deviation, to the 0.9830-0.9870 area. The options market also suggests that a worst-case scenario (a two standard deviation drop) could see EUR/USD trade close to 0.9500-0.9550. In the same article, we highlighted which combination of global risk sentiment and Fed-ECB policy differential (measured by the MSCI World index and the 2-year EUR-USD swap spread, respectively) could cause a decisive break below parity. That scenario analysis implied quite a limited short-term risk premium in EUR/USD, but the growing tail risk of Russia halting gas flows to Europe means that that risk premium is now growing rapidly – and given the extraordinary nature of recent developments, may well prove stickier to be unwound that on other occasions.
It is no secret that the ECB dislikes a weak euro, and today we’ll see whether one of the last governing council speakers before the “quiet period” – Francois Villeroy – addresses this topic. For now, it appears that the ability of the ECB to lift the currency is, however, quite limited. On the data side, the ZEW readings for July will be in focus, with a high chance of another big slump in both the “expectations” and “current situation” gauges, all of which should fuel fears of a major downturn in the eurozone.