Nordea examines the Euro outlook in its latest weekly report and looks at three key Euro-to-Dollar (EUR/USD) exchange rate impact.
Image: EUR/USD exchange rate chart
Two of these elements have been important focus points during May and Nordea expresses some surprise that they have not attracted more attention within markets.
“We find investors surprisingly uninterested in the potential debt game changer for the EUR, even if the Franco-German debt proposal will face a truckload of obstacles this week. It may be worthwhile buying a EUR lottery ticket in option space.”
According to Nordea, minutes from the May ECB policy meeting suggested that the Council was not overly concerned over the risk to its bond-buying programme from the German Constitutional Court ruling.
The bank considers that German politicians, led by Chancellor Merkel, would not allow the Court to block Bundesbank bond buying. “We see a very low risk that the Karlsruhe ruling will prove to be a medium-term obstacle for the ECB.”
The second key element is the Euro-zone recovery fund proposed by France and Germany. Their plan calls for a EUR500bn rescue package which would be in the form of grants and funded through bonds issued by the EU Commission.
According to Nordea, the Euro area has continuously struggled since its inception given that no common fiscal firepower has been available. This has left several Southern European member states, such as Italy, trapped with rising debt burdens and no significant growth.
There has been opposition to the Franco-German plan with the Netherlands, Sweden, Denmark and Austria maintaining their opposition to debt mutualisation and calling for support instead in the form of low-cost loans.
The EU Commission will announce details of its own recovery proposals on Wednesday and there will be a key Summit in June.
Any agreement on a substantial support package would potentially provide strong euro support.
“If push comes to shove and some sort of de facto EU debt proves to be the future name of the EU-game, it will likely be a game-changer for EUR-markets, even if the initial common debt size isn’t a biggie.”
According to Nordea most investors expect a watered-down plan at the EU-27 summit, which leaves a pretty good risk/reward in buying Euro options.
Nordea also considers a third aspect regarding financial reform which has received much less market attention.
EU Lawmakers have looked at reform of the MiFID II legislation which is designed to greater protect investors, consumers and other businesses when it comes to financial services.
According to Nordea; “the EUR has generally struggled versus USD during the relative tightening of Euro area regulatory burdens versus peers in the US.”
In effect, the tighter element of regulation has stifled activity and profitability within the financial sector which has tended to limit capital inflows into the Euro area. The Euro-zone banking sector has consistently under-performed relative to the US and Nordea considers this has been an important factor undermining the Euro.
Image: Euro mifid
In this context, any revision of rules would tend to be a Euro positive and Nordea considers that a roll-back in isolation would add as much as 10 big figures for EUR/USD.
“If we assume that i) MIFID II is rolled back and ii) that 3M EUR-USD hedge costs remain as low as currently, we make the case that >1.20 readings in EUR/USD could be on the cards.”
Even if only one of these aspects comes to fruition, there would still be potential net Euro support.
Nordea, however, is wary over the risk of weaker risk appetite during the next few weeks which would tend to trigger renewed defensive dollar demand and limit scope for EUR/USD support.
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