The euro faces growing downside risks

Global developments have taken a turn for the worse for the euro. Fears of a recession in the US have risen further (supporting the safe-haven US dollar), market scepticism has grown about the credibility of the European Central Bank’s (ECB) upcoming ‘anti-fragmentation’ tool and, crucially, the market has been further discounting a deep energy crisis in the euro area. As a consequence, the euro has declined sharply, recently posting 20-year lows against the US dollar.

With the outlook for Russian gas supplies looking highly uncertain, the risk that euro area countries will have to ration energy cannot be ignored. This would have a significant impact on economic activity and have a knock-on effect on the euro. The main specific threat currently is that Russian gas flows through the Nord Stream 1 pipeline will not resume after the scheduled end of seasonal maintenance on 21 July. This has led to a further spike in natural gas prices, even though the price of many other commodities has started to decline. Adding to the energy concerns is the inability of alternative sources of electricity to fill the gap because of maintenance issues (notably at French nuclear plants) or because of drought (especially threatening hydro-electric generators). While our central scenario remains that the euro area will experience a ‘mild’ recession by the turn of the year, the risk of energy rationing and the squeeze on real incomes mean it could be more severe.

While we believe current market fears may not fully materialise and while a number of factors supporting the euro are being overlooked (such as sharp improvements in net capital flows into euro area securities), we are also wary of sending too optimistic a message in the short term on the euro. As a result, we have decided to lower our three-month projection for the EUR/USD rate to USD1.00 (from a previous USD1.06). This mechanically lowers our six and 12-month projections to USD1.05 and USD1.09, respectively (from USD1.11 and USD1.15). We will reassess our latest projections after the ECB’s next scheduled policy meeting on 21 July. 

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