The Euro is Saved! Now What?

Euro Headed To Parity?

On July 13th, Greece and its European creditors announced an agreement intended to resolve the current crisis. Although the IMF has protested that there is too little commitment by the creditors to write down debt, it appears that markets are slowly starting to normalize. Though the Greek stock markets have yet to open and there are still limits on withdrawals and fund transfers, Greek banks did open their doors. Greek government interest rates dropped sharply; for example the 10Y rate, while still a very high 11%, is almost half the 19.4% rate at the peak of the crisis.

Although the sense of crisis seems to be slowly priced out of the market, EURUSD has since weakened to trade at close to a 3-month low. There are several possible explanations for why EUR might weaken in response to what appears to be good news. Indeed, it is possible that the market had anticipated that a Greek exit would improve the prospects for EUR. But the chart above suggests that the Greek crisis has not been a major factor driving the euro – at least directly. For the past 18 months, EURUSD tracked the spread between 2Y US and German government bond rates, which are indicative of what the market is pricing for central bank tightening. Arguably, the Greek crisis may be indirectly affecting EUR by changing expectations on ECB rate policy, but EUR was actually stronger than the rate-spread implied level throughout the crisis period. So the subsequent weakness puts EUR back in alignment.

Europe Needs More Liquid Diet

The chart below shows EUR performance is also driven by relative economic growth. Greece is not the only country in Europe focused on reducing government spending and repaying debt so there is the prospect of substantial fiscal contraction in the coming year. The combination of weak economic performance and easier monetary policy does not bode well for the currency. That said, EURUSD looks roughly in line with growth so it is difficult to get aggressively bearish on the currency at current levels.

Source: Eikon

The EUR Is Already Weak…

…especially vs. the USD. The chart to the left shows that, in real – CPI adjusted – terms, EUR is trading at the lowest levels in over a decade. In part, this represents extreme USD strength – the BIS dollar index is near its 12-year high. While less extreme than the dollar leg, EUR is also relatively weak on a broad trade-weighted basis as well. And the Euro-zone has been registering a substantial current account surplus over the past year. So on this front it is also difficult to get terribly bearish on the currency.

Source: Eikon and Bank of International Settlements

But It May Not Be Saved

Another explanation for why EUR did not benefit from diminished Greek default risk is that the market is not yet pricing a resolution of the crisis. Greek bonds did rally, but, as shown below, they are still pricing in substantial default risk. And while there might be some recovery when the market opens, it is likely that Greek financial stocks will continue to severely lag the positive performance in most other European markets – especially Germany. So the market still seems to be pricing in substantial risk of a Greek default and exit from the Euro. And contagion risk appears to be priced into the Portuguese market as well. We believe that EUR at current levels is roughly consistent with the current outlook for European interest rates and economic performance. We think more extreme break-up risk remains the primary source of downside risk – particularly if Spanish financial stock markets join Greece and Portugal in negative territory.

Source: Eikon

Ron Leven is the head of FX Pre-Trade and Economic Strategy at Thomson Reuters. Ron joined Thomson Reuters in January 2014 with over 25 years of FX investment strategy experience on both the buy- and sell-side firms, most recently as head of FX derivatives strategy at Morgan Stanley.

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