The euro is overdue for a correction. For the past two weeks, it quietly traded higher before consolidating within a narrow range versus the U.S. dollar. Throughout this time, there’s been bad news for both Europe and the U.S., but Europe’s troubles are deteriorating quickly. There are no shortages of reasons for why EUR/USD should be trading closer to 1.16 than 1.18, but here are the four most important:
1. Second Virus Wave Spreading Across Europe
New coronavirus cases are exploding in Europe, raising concerns that the region could return to the tough times experienced at the start of the year. Daily infections hit a record high of 18,746 on Wednesday in France and are hovering near 10,000 a day in Spain. To put this into perspective, back in March, cases in France peaked at 7,578 and in Spain, 9,159. Only four countries in Europe are below the critical 20 cases per 100,000 threshold set by the European Centre for Disease Prevention and Control. The second wave is spreading across Europe, with Germany reporting more than 4,000 cases over a 24-hour period. In Italy, new cases hit 3,678, the highest in five months. Countries across Europe are imposing new restrictions. Paris is at its highest alert level. Spain instituted an earlier closing time for restaurants and limited travel in and out of cities. Germany announced a curfew and restrictions on gatherings. Italy made masks mandatory outdoors across the country. Belgium closed bars and restaurants for a month, while Ireland’s health department recommended placing the whole country on the highest level of restrictions.
2. Partial Lockdowns Could Mean Double-Dip Recession
These partial lockdowns will kill the Eurozone’s recovery. During the summer, economists predicted a second-half recovery for the region. Now, it will be lucky if it can escape a double-dip recession. We are just beginning to see deterioration in Eurozone data, but next month, when the October numbers are released, we’ll learn just how damaging these new restrictions were for the economies. In the second quarter, Eurozone GDP contracted 11.8%. We may not see double-digit declines this time around since governments are trying to avoid full lockdowns, but there’s a very good chance of a contraction in the fourth quarter. The impact on the euro could be significant because back in March, the single currency dropped from a high of 1.15 to a low of 1.0637 in a matter of weeks. There was also tremendous volatility as investors took stock of the damage to the economy.
3. More ECB Easing
Unless Eurozone nations suddenly get these outbreaks under control, it is widely believed that the European Central Bank will need to increase its Pandemic Emergency Purchase Program at the end of the year. On the basis of inflation alone, which hit a record low in September, more easing is needed to meet their mandate. However, now that the second-half recovery is at risk, the central bank will have no choice but to provide additional support to the economy. An interest rate cut is also on the table, but it's seen as less effective than expanding or extending PEPP. ECB President Christine Lagarde confirmed this week they are ready to inject fresh stimulus after describing the recovery as “a little bit more shaky” and saying they are “prepared to use all the tools that will produce the most effective, efficient and proportionate outcome.”
4. U.S. Election Uncertainty
Lastly, the extraordinary performance of U.S. stocks and the remarkable speed of the President’s recovery from the coronavirus should also create demand for U.S. dollars, but it is U.S. election uncertainty that could drive investors out of euros. Risk appetite and the rally in stocks are the only reasons why the euro refuses to fall. Every positive U.S. stimulus headline lifted the currency, but as the election nears, so does the uncertainty. That could lead to broad-based profit-taking at which point the euro could suffer greatly.