Analysis-Euro peers over the cliff at dollar parity as recession looms

div classBodysc17zpet90 cdBBJodivpBy Saikat Chatterjeep

pLONDON Reuters – The euros drop to a fiveyear low is rekindling the possibility the currency will reach parity versus the dollar for the first time in two decades, as fears of a euro zone recession encourage investors to pile on the bearish bets.pdivdivdiv classBodysc17zpet90 cdBBJodiv

pRussias move to cut off gas supplies to Bulgaria and Poland is the latest blow for the currency, already pressured by the twin headwinds of a surging dollar and sweeping COVIDlinked lockdowns in China, a major market for bloc exports. Germany and other European countries could be next in line for restrictions on gas.p

p“The embargo could tip the European economy into recession sooner than later and as a result we are short the euro expecting it to weaken to at least 1.05 in the near term and maybe towards parity,” said Kaspar Hense, a senior portfolio manager at Bluebay Asset Management in London.p

pAs the single currency plumbed a low of 1.0514 against the dollar, bringing April losses to 4.5, some highfrequency financial and economic indicators are flashing red. p

pData in the euro zones biggest economy Germany showed consumer morale at a historic low and the government sharply cut its 2022 growth forecasts . A credit default swap index showed the cost of insuring exposure to lowerrated European debt is at its highest in two years, highlighting risks companies face.p

pMore downside is likely, said Vasileios Gkionakis, EMEA head of G10 FX strategy at Citi, adding that “speculative positioning is much cleaner than before, suggesting scope for bigger ‘short’ accumulation.”p

pIndeed, onemonth eurodollar risk reversals — a option market gauge of demand for options on a currency rising or falling — moved sharply on Wednesday to imply more euro weakness. p

pThe ratio of call options on the euro compared to puts almost halved on Wednesday from the previous day to minus 1.8, the lowest since earlyApril. Call options confer the right to buy an asset while puts enable holders to sell. p

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ppGRAPHIC: Euro risk reversals https:fingfx.thomsonreuters.comgfxmktgkplgkbwnvbeuro20risk20reversals.JPGp

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ppTHE LESSER HAWK p

pThe euro has moved steadily lower since peaking at 1.6 in 2008, deriving little benefit from expectations the European Central Bank may raise interest rates this year by 80 basis points.p

pThats because markets are prepped for far more aggressive tightening from the U.S. Federal Reserve, with money markets betting U.S. rates will rise by 1 in the next two meetings. p

pECB rates, currently at 0.50, wont rise to U.S. levels this year or the next.p

p“In the euro zone, youre really only talking about getting that deposit rate out of negative territory and maybe back to slightly positive territory by year end. What that means is that the European currency depreciates,” said Craig Inches, head of rates at Royal London Asset Management.p

pInches highlighted the euro‘s slump against trading partners’ currencies as worrying for bond investors as it can exacerbate the blocs 7.4 inflation rate.p

pA worsening inflation outlook because of currency weakness “makes us assess the value of bond yields… are we being compensated in longerdated bonds for the inherent term premia and future inflation risk,” he said, adding that 10year German bonds made little sense at sub1 yields.p

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ppGRAPHIC: Euro tradeweighted https:fingfx.thomsonreuters.comgfxmktzgvomlarkvdeurotradeweighted.JPGp

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ppHURDLES TO PARITYp

pA move to eurodollar parity wont be straightforward, with currency traders facing some stiff technical barriers. p

pEuro downside is guarded by sizeable option contracts around the early2017 low of 1.0340, and then the 1.02 level last hit December 2002, according to two traders.p

pSwift moves might also invite ECB intervention, last seen in 2000 and 2011, especially if euro weakness sparks bond market blowouts in weaker states such as Italy.p

pThe latest drop may be partly down to a positioning cleanout — weekly data from Commodity Futures Trading Commission showed hedge funds broadly neutral on the euro, with short positions well off highs seen in early2020. .p

pFor those reasons, few banks are willing to forecast eurodollar parity will be hit HSBC for instance says the 1.0341 level of early2017 may heave into sight “if macro and political challenges dont abate.”p

pRabobank said it would reconsider its 1.10 euro forecast, noting the “strongerforlonger” dollar, but expects “eurodollar parity will be sidestepped” if energy supply disruptions are averted and ECB policy tightening stays on course.p

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ppGRAPHIC: Euro slides to fiveyear lows https:fingfx.thomsonreuters.comgfxmktzjvqkmyxbvxeuro2704.PNGp

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pp Reporting by Saikat Chatterjee additional reporting by Dhara Ranasinghe editing by Sujata Rao and Toby Choprap

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