As the battle for Ukraine rages on, the single currency is in its own fight for survival
Evolving into arguably the most serious security threat to continental Europe since the Second World War, the invasion of Ukraine by Russia couldn’t have come at a more economically precarious time for the EU. With a recurrent energy crisis providing instability, bloc states and policy makers have been busy trying to spur on an economic recovery from the pandemic amid the increasing threat from inflation. But diverging priorities and opinions have made this a challenge, as some states remain sensitive to tightening monetary conditions while others have a lasting, tainted memory of inflation spiralling out of control. The current shift in the geopolitical and economic environment under way could prove challenging for the euro as a currency, and potentially the union as a whole.
Another decade, another challenge for EUR
The euro has experienced a fair share of challenges in the just over two decades since its adoption. Predictable issues such as fiscal responsibility, which has led to sovereign debt crises and overall banking sector instability, or slow and uncoordinated policy responses have made for a difficult macro backdrop, particularly since the global financial crisis. Annual growth in the first two decades of the currency union averaged just 1.37%. One could argue that EURUSD has indeed been in a long-term bear market ever since the all-time high of the pair was reached in July 2008. Looking ahead, with a commodity price shock across energy and food, poor economic potential and fundamentals, and a significant conflict all at play, the EU may find that it is only just now at the start of an analogue to 1970’s America – think OPEC embargo, recession of ‘73-’75, and Vietnam. Caveating that this earlier period also coincided with Nixon nixing the gold standard, this was a decade where the USD lost 30% of its value.
Spectre of stagflation casts its shadow
Much of the decline in dollar strength through the 1970’s boiled down to stagflation. Earlier this week, headline inflation in the Eurozone hit a high of 5.8%, while the number of 10bps rate hikes by the ECB expected this year by the market were more than halved. For context, this expectation means a still-negative target rate of around -0.3% by the end of the year, while the ECB continues to buy assets all along the way. Unsurprisingly, EURUSD has simultaneously hit lows going back to the initial pandemic shock this week, as rate differentials versus the US widen and the spectre of stagflation casts its shadow. Supply side practicalities further complicated by Russian sanctions will dictate exactly how much additional pain is inflicted on the European economy, which is caught in the conundrum of dissipating growth and rising inflation.
Trapped ECB favours early roll of hedged positions
Given the prospects, hedging, re-hedging, or topping-up EUR exposure may be a timely decision. With the current crunch for dollar funding providing a basis over and above the widened yield differential from a ‘trapped’ ECB, carry benefits are at multi-year (or in some cases all-time) highs. This means an early roll of hedged positions or tenor extensions can be beneficial. The weaker euro also allows for hedge re-striking to mean positive mark-to-market cash inflow for any hedges put in place over the last two years. Being well positioned to weather the potential storm will be important in an era of increasing geopolitical and currency volatility. If nothing else, we may take some solace that the unity displayed in the face of this crisis may be auspicious for future policies, integrative measures, and growth.