The EU’s 27 member states have approved a EUR 750 billion COVID rescue plan following an intense four-day and four-night negotiating session.   They also agreed that the European Commission will borrow the money from financial markets directly, breaking the long-held taboo against debt mutualisation.  This is a meaningful first step in addressing the structural flaws of the single currency, but it still appears premature to conclude that the tide has turned for EURUSD.

We did it!  Europe is strong.  Europe is united.

–  Charles Michel, President of the European Council, July 21st 2020

This is a one-off.

–  Mark Rutte, Dutch Prime Minister, July 21st 2020

Nothing is so permanent as a temporary government program.

–  Milton Friedman, ‘Tyranny of the Status Quo’, 1984

During the first quarter of 1995, they caught me long the dollar while it receded 20 percent against the yen.  I was also facing the wrong way when the dollar exactly retraced its decline during the last half of that year, going up 20%.

–   Victor Neiderhoffer, ‘The Education of a Speculator’, 1997

The size of the EU’s COVID rescue package announced on Tuesday, and christened the ‘Next Generation EU’ (NGEU), is a little smaller than originally envisioned by Merkel and Macron.   In addition to shrinking the package from EUR 500 billion to EUR 390 billion,  the ‘Frugal Four’ (the Netherlands, Austria, Denmark and Sweden) have also succeeded in including a few more controls over how the cash is disbursed. 

However, these ‘victories’ should not hide the fact that this is a big deal for champions of European integration.  The numbers may be smaller, but the ability of the EU to raise these funds independently from member states, by raising debt directly in the financial markets, is de facto debt mutualization and, arguably, a step towards federalization.

Mark Rutte may claim that this is a temporary ‘one-off’, but, as Milton Freidman recognized decades ago, it can be very difficult to roll back these powers once they have been granted. As with income taxes and quantitative easing, the state has a way of institutionalizing revenue-raising powers once it gets its hands on them.

This seems, on the surface, to be very good news for the euro.  The Achilles heel of the single currency has long been the fact that it is a currency union without a financial (or fiscal) union.  It exists only at the pleasure of its member states and as such, it was seen by the market as being less stable and more subject to geopolitical risks, like those seen during the Greek crisis in 2015 and mirrored more recently in concerns over Italy’s growing and unsustainable debt pile.

It is not surprising, therefore, that we have seen EURUSD rally back up towards its 12-month highs in the run-up to this historic deal.  If the euro de-risks itself and rids itself of its geopolitical risk premium, then maybe it can finally rival the mighty US dollar as a truly global currency and safe haven.

In fact, this narrative, that the US dollar’s dominant position in global markets is coming under threat, is gaining momentum.  This is not particularly surprising as the US struggles to contain the COVID crisis, and US government debt is expected to soar above 120% of GDP this year.  Throw a volatile Presidential election campaign into the mix and this does not sound much like a safe haven.  

Now that its structural flaws seem to be at least partially addressed, the euro, backed by a ‘state’ with (relatively) lower aggregate debt levels, strong current account surplus and demonstrated competency in general pandemic management might seem an appealing alternative.  The recent rally in EURUSD (Chart I), which threatens to break the current down-trend, is, in part, a result of the traction that this narrative is gaining in the market.

Chart I: EURUSD (5 Year)

Source: Bloomberg

While EURUSD did rally in the lead-up to the NGEU deal, and it has (so far) held on to these gains, it is in some ways surprising that the move was not stronger.  Even though the euro has seemingly resolved a key deficiency, and the US is doing everything but explicitly devaluing the dollar, the euro has failed to convincingly break through its recent highs.  On a long-term chart (Chart II), the evidence is even more compelling.  Despite the recent rally, the long-term trend for EURUSD remains lower.

Chart II: EURUSD (10 YR)

Source: Bloomberg

In our view, it is still too early to call time on the US dollar’s bull run.  As a recent paper by the IMF, entitled ‘Dominant Currencies and External Adjustment’1, suggests, the US dollar is firmly entrenched at the centre of our global financial system, both in terms of pricing (23% of global exports, excluding commodities, are priced in US dollars) and financing (about 40% of the world’s debt is issued in dollars).  

This does not make the US dollar invincible, but in a ‘risk-off’ environment with high levels of market and geopolitical risk, it increases its appeal as a store of value.  If you had to commit to being paid in a single currency (excluding your home currency) for the rest of your life, which currency would you feel most confident in?  My guess is that many of you would pick the US dollar, despite its flaws.

The current momentum, and the dominant market narrative, favours further upside in EURUSD.  A break above 1.15 does look increasingly likely, which would open of further moves towards long-term resistance between 1.16 and 1.17.  For now, however, we feel it is too early to definitively call a turning point in the dollar.  What is clear is that we are at a critical juncture for the US dollar.  A reversal of the current downtrend could see a strong bounce towards 1.30, and similarly, should the trend hold, we would expect to see a test of parity in the months ahead.

Legendary FX trader Victor Neiderhoffer described a trend in financial markets which he called LoBagola analysis (named after the movement of elephants), whereby markets make a historically large run in one direction until, at some unpredictable point, they reverse in an equally extreme run back to where they began.  If the US dollar bears (who anecdotally make up at least 90% of the market!) are correct, we are on the verge of such a move and, as risk managers, we must be prepared for that possible outcome.

Author: Kevin Lester, CEO