Sleeping giant awakens? Downside risks for euro grow

A drop in the euro/dollar exchange rate to a four-month low raises the prospect of a repricing of one of the world's most important macro-economic metrics and a potential re-rating of the US currency across the globe.

After settling into the narrowest trading range in the euro's two-decade history in 2019, the euro's latest drop in the past week raises concern about a broader decline.

The US economy is outperforming its European counterpart while the impact of the coronavirus on the Chinese economy and consequently the German economy, Europe's powerhouse, has yet to show up in data.

Citigroup's economic surprise index for Europe has slumped to a four-month low .CESIEUR while a similar gauge for United States has .CESIUSD jumped to a five-month high after dismal German industrial data and strong US jobs figures last week.

"Last year we discovered how sensitive the German economy was to China, and I think everybody is still underestimating the impact this will have on the Chinese economy and to Europe," said John Marley, a senior FX consultant at the FX risk management specialist SmartCurrencyBusiness.

The world's most actively traded exchange rate EUR= has weakened nearly 2 percent in the past week to $1.09. It's less than 5 percent away from a 17-year low of $1.03 reached in January 2017.

Euro weakness has implications not only for European policymakers when they are debating more stimulus, but also could signal further dollar strength and lead to tighter financing conditions from China to Mexico.

The euro has been under the gun for the last year or so, thanks to a relentless drop in market volatility. The latest data have only encouraged euro bears.

Subdued price swings, at least in theory, should hurt all currencies that have low or negative interest rates, such as the euro, the Swiss franc and the Japanese yen, as hedge funds typically borrow in them to invest in higher-yielding currencies such as the US dollar or emerging markets.

But the euro's case is unique in its zero correlation to geopolitical events. That means a yield-seeking strategy of borrowing in euros and investing in dollars can be profitable, even through episodes of missile strikes and virus attacks.

"That negative yield and the falling volatility makes the argument of buying and holding euros a very tough one," said Elsa Lignos, global head of FX strategy at RBC Capital Markets in London.

In 2019, borrowing in euros and investing in US dollars would have generated a return of nearly 5 percent. By comparison, borrowing Swiss francs last year and buying US dollars would have only yielded a return of 1.7 percent. Borrowing Japanese yen would have earned just 1.5 percent.

That has encouraged euro bears. Hedge funds have been ramping up their net short bets in recent weeks; net short positions are not far from a three-year high.

That would give plenty of food for thought to forecasters in a Reuters poll who are predicting more strength for the euro over the next 12 months. FXPOLLS