By the time European Union leaders announced on July 21 that they had agreed a €750 billion package to help member states recover from the impact of coronavirus, EUR/USD had risen to 1.1475 from 1.1176 just a month earlier.
Expectations of 1.15 on the day were stymied by the composition of the package, specifically that almost half its total value is in the form of loans rather than grants.
But the euro has continued to rise, with the market viewing the deal as evidence that the European Central Bank backstop is intact and that the risk of European break-up remains low.
According to Deutsche Bank strategist George Saravelos, the euro-higher trade over the coming months is all about whether or not European growth outperforms that of the US. With indicators such as restaurant visits suggesting that this divergence is accelerating, Deutsche remains bullish, targeting 1.20.
Jari Stehn, chief European economist at Goldman Sachs, describes the agreement on the recovery fund as an important political signal that further European integration is possible. He expects EUR/USD to strengthen to 1.25 over the next 12 months.
Euro vs dollar
The ability of the EU to secure a deal compares favourably with the situation in the US Senate, where Republicans and Democrats have been unable to agree on the make-up of the latest fiscal stimulus package.
“We have seen the euro emerge as one of the go-to safe-haven currencies,” says Societe Generale’s head of corporate research, FX and rates, Kenneth Broux. “More investors now want to own the euro in their portfolios, although it must be stressed that dollar weakness has also contributed to a higher EUR/USD.”
The recovery fund effectively complements the whatever-is-necessary rhetoric of the ECB and will stop investors betting against the reversibility of the euro
– Kenneth Broux, Societe Generale
He adds that by coordinating the response of the 27 member states via the common EU budget between 2021 and 2027, the European deal removes the asymmetric downside risk for the single currency.
“The recovery fund effectively complements the whatever-is-necessary rhetoric of the ECB and will stop investors betting against the reversibility of the euro,” says Broux. “The dollar has long been expensive in valuation terms. We don’t know what will happen in the case of a second wave, and a return of corporate demand for dollar liquidity may deflate EUR/USD, but I believe EUR/USD could be on course for a return towards 1.20.”
Sam Lynton-Brown, head of G10 FX strategy Europe at BNP Paribas Markets 360, says that agreement on the recovery fund reduces the downside tail in Europe, in turn enabling the euro to participate in broad dollar weakness.
“Eurozone investors (along with Japanese investors) have the largest exposure in USD assets,” he says. “Each currency remains significantly cheap versus long-term equilibrium, implying plenty of scope for EUR (and JPY) to rise and catch up with higher beta currencies.”
Lynton-Brown describes the size of the fund, the division between grants and loans, governance on grant distribution, the degree of burden sharing and the loan terms as encouraging, and observes that his bank is also bullish and positioned long EUR/USD.
“We see scope for EUR/USD gains to become more volatile, and therefore think being long both spot and vol is attractive,” he says.
The European recovery fund has been described as the EU’s ‘Hamiltonian moment’, in reference to the decision of the US federal government to assume all the debt incurred by states during the war of independence under the direction of the country’s first treasury secretary, Alexander Hamilton.
Although reluctant to go quite that far, BNY Mellon Markets senior EMEA market strategist Geoff Yu says the willingness of Germany to recognise the need for common resources to invest in Europe is potentially an important step towards future optimization of the currency union.
“We expect the euro to drift higher over the next few months as its Covid-19 response and recovery stands to outperform that of the US,” he continues. “Even though it will take time for the results to come through, the direction of travel – coupled with material underweighting of Europe in global asset allocation – is positive for the currency.”
However, Yu also cautions against pushing the euro too much too quickly as it could further eat into eurozone inflation, which is already running at very low levels.
“Evidence of imported disinflation from a strong euro would immediately generate a policy response,” he concludes.