Journalists are unmatched in their appreciation of a round number. That’s why your newsfeed is about to be clogged with stories marking the euro hitting parity with the dollar for the first time since December 2002.
The second paragraph of the story will probably say something about how the euro’s down more than 12 per cent this year as investors chose the greenback over riskier assets. Worries about aggressive central bank tightening amid inflationary pressures have triggered a flight to safety, it’ll continue, before quoting some strategist or other about how there’s definitely probably a ~50 per cent chance of imminent recession.
Such formulas are applied because the euro’s hitting parity on a data-free day, so everything has to look backwards. It’s worth bearing in mind, however, that by far the most significant event in the rear view mirror is Russia’s tightening of gas flows.
Whereas a widening of peripheral spreads hurt the euro in April and May, the big concern since mid June is the more than doubling of regional gas prices. In that context, recent market moves can only really be explained by deteriorating growth expectations as Russia turns the screw. Here’s how SocGen’s Kit Juckes frames it:
EUR/USD doesn’t always track relative rates, but it tracks relative rates more/better than it follows anything else. Short rates perform, over the long run, better than long ones as an explainer of EUR/USD and [the below] chart shows futures-implied 3-month rates in two years’ time. It shows how the most recent fall in EUR/USD hasn’t really been rate-driven.
[The next chart] shows this year’s picture, adding the nuance that rates had helped the euro bounce in May, but since the start of June, the euro has fallen, irrespective of rate differentials moving first in its favour and then against it. It’s all about the risk backdrop and the threat to European growth from energy dependency, which in turn, is now affecting longer-term rate expectations.
And because we’re all about gas, not monetary policy or investor sentiment, it’s almost impossible to talk about euro support levels. JP Morgan will give it a go though:
Russia has potential incentives to withhold gas supplies and (2) that the fallout on EUR in such scenarios would be sobering. On the Russia side of the equation, curtailing supply is a way to trade economic damage for other concessions. Doing so in gas has lower impact on domestic growth as it comprises one-fifth of Russia’s budget revenues unlike oil which makes up over half. . . . On the euro side of the equation, energy dependence remains the major point of vulnerability. The region imports 65% of its overall energy needs. Share of gas in the energy mix ranges is high for the largest countries—40% for Italy, 26% for Germany and 24% for Spain. Moreover, more than 80% of this gas is imported. Hence, curtailed supply from Russia can have outsized and non-linear impact on the economy.
In an adverse scenario in which gas flows are completely shut off, the Bundesbank has a 6% GDP hit to Germany in the first year (~ 4-5% off EU GDP). Our FX team estimate that EUR/USD is currently pricing in 20% to 25% odds of the adverse scenario of shutdown of Russian gas supply. EUR/USD is currently undershooting, specifically with a discount of 3% adjusted for the growth revisions we have had thus far and hence by our estimates price in an additional 1%pt decline in Euro area growth vs. the US (vs. the 4-5%pt hit to GDP that could occur in the stress scenario). A typical rule of thumb is that every 1%pt change in Euro area GDP relative to the US is worth 3% on EUR/USD.
Over at Goldman Sachs, they reckon that for every 1 percentage point fall in euro area growth expectations it’s only 2 per cent off the euro. By Goldman maths, the fuel crisis has cut year-ahead GDP of about 0.75 of a percentage point, which would match the euro’s move in recent weeks.
Deterioration also makes the worst case scenario more likely, however, and that’s not yet in the price:
For what it’s worth, here’s what Goldman thinks about the nearly definite probable ~50 per cent chance of imminent recession. What’s important isn’t the likelihood, it argues, but the type:
[Goldman] economists think the chance of a downturn over the next year is elevated in the US (30%), the UK (45%), and the Euro area (50%). But these figures only tell part of the story because the type of recession risks we envisage are quite different across jurisdictions. In the US, our economists see an elevated chance of a cyclical, policy-induced recession which—if it occurred—seems likely to be fairly shallow, along the lines of the 2001 or 1990 recessions. Private sector balance sheets are very healthy and the Fed would have some room to reverse any over-tightening. On the other hand, recession risks in Europe are primarily politically-driven; the prospect of Russia cutting off gas flows raises the spectre of a severe downturn despite relatively positive economic fundamentals. Under these circumstances, our baseline for the Euro area economy is already not far off from the “shallow recession” downside scenarios we see in the US, with a clear risk of a much more protracted “sudden stop”. We think the sharp FX market moves over the past week, led by EUR/USD, primarily reflect these stark differences in the scope of downside risks.
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