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Euro Braces For 2020 Ahead of Trade Wars, Debt Risks, Slow Growth

Euro Braces For 2020 Ahead of Trade Wars, Debt Risks, Slow Growth

2019-12-27 08:00:00
Dimitri Zabelin, Analyst
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Euro, Trade War, ECB– Talking Points

  • Euro outlook gloomy as political, debt risks threaten regional stability
  • Escalating US-EU trade war tensions may pressure the Euro and ECB
  • What is ECB recommending member states do to counter a downturn?
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While the Euro has staged a mild recovery in the last breathes of 2019, its recent upside progress may only be a deviation before it resumes the dominant downtrend against its US Dollar counterpart. Mounting fundamental risks in 2020 including EU-US trade tensions and regional debt risks which could stoke ECB rate cut bets and pressure the currency.

German Economy Outlook

The German economy – the largest in the Eurozone – only narrowly missed a recession this past year as demand from its EU neighbors faded amid a global slowdown and the US-China trade war. Environmental regulations also hindered Germany’s auto sales, a key factor in the export-oriented economy. If growth continues to slow and Germany experiences a recession, this could boost ECB rate cut bets and hurt the Euro.

The ECB and Lagarde's Limits

Prior to being sworn in as the new ECB President, Christine Lagarde said that there is still room to cut interest rates further into negative territory. This comes as monetary authorities continue to expand the bank’s balance sheet in an effort to push Eurozone inflation figures closer to their 2 percent target. But do market participants believe the central bank will be able to achieve its objective?

The Euro 5Y5Y inflation swap forward – a key inflation expectations gauge – has risen a little over 17 percent from its all-time low reading at 1.1150. Its ascent came as Eurozone data began to rapidly improve and outperform economists’ estimates. However, brewing tensions between the EU and US could end with a full-scale trade war and sap confidence in sustained upside inflationary pressure. But more on that later.

Chart showing EUR 5Y5Y Inflation Swap

With the ECB already operating with negative-interest rates and QE indefinitely, investors are questioning the effectiveness of additional stimulus in the case of a downturn. While Mrs. Lagarde has stressed the importance of European governments to increase spending, the institutional rigidity of the Eurozone makes it difficult for members states to exercise their own fiscal autonomy. Look at what happened in Italy in 2019 when they tried.

Side Effects of Hyper-Accomodative Monetary Policy

While the ECB’s ultra-aggressive easing measures did help the Eurozone recover, the specter of its earlier actions may start haunting European markets. With interest rates so low, it has left yield-starved investors searching for greater returns and often directing their capital to riskier assets. This helps explain the recent explosion of the leveraged loan market and greater issuance of covenant-lite debt obligations.

If a sizeable portion of high-risk debt becomes delinquent, it could trigger a regional equity selloff and pressure the Euro. The spread on the Market iTraxx Europe Crossover index – which consists of “75 equally weighted credit default swaps (CDS) on the most liquid sub-investment grade European corporate entities” is hovering at all-time lows.

However, the cost of insuring these debt obligations could skyrocket – and may be reflected in a wider spread on the CDSs – if regional risk aversion pressures European stock markets. This may then stoke ECB rate cut bets and bring the timeline for easing closer and potentially catalyze a Euro selloff. To learn more, register for my weekly webinar here.

Chart showing Euro Stoxx 50

Is an EU-US Trade War Up Next?

EU-US trade tensions are once again resurfacing despite the truce between then-President of the European Commission Jean-Claude Junker and US President Donald Trump in the summer of 2018. In addition to the Airbus dispute where the US was awarded the right to legally impose tariffs against the EU – with Europe’s pending case against Boeing – France recently issued a digital tax that angered Washington.

Mr. Trump said the French law unfairly targeted US tech companies and threated to impose levies ranging from wine to luxury handbags. Paris responded that it would be ready to retaliate against the US, with officials in Brussels signaling they too would retaliate against the US as one. It appeared as the economic equivalent of Article V of the North Atlantic Treaty Organization: an attack against one is an attack against all.

Furthermore, United States Trade Representative Robert Lighthizer declined to answer on whether or not auto tariffs were back on the table. This prospect made markets particularly nervous since it would hit Germany the hardest. With Trump’s surface-level victory with China over trade, it could embolden “tariff man” to employ similar measures across the Atlantic.

Escalating EU-US Trade Tensions May Amplify EUR/USD 10-Year Downtrend

Chart showing EUR/USD

EUR/USD chart created using TradingView

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--- Written by Dimitri Zabelin, Jr Currency Analyst for DailyFX.com

To contact Dimitri, use the comments section below or @ZabelinDimitrion Twitter

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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