EURO: Political Risks Largely Under Priced

The trend within the Eurodollar has largely been one of strength recently as the venerable pair has seen great buoyancy following the sliding rate hike rhetoric from the US Fed. However, there is a range of mounting political and economic risks within the Eurozone that have been left largely unpriced.

Over the past few weeks the Euro has soared to new highs, largely driven by divergences within central bank policy and expectation setting. However, the common currencies strength might have finally reached its glass ceiling given the robustness of the recent US ISM Non-Manufacturing PMI result. The result proved relatively strong at 54.5 and subsequently pointed to a firming US Services sector. However, despite the strong result, the Dollar’s sentiment remained largely unchanged and did little to dent the Euro’s meteoric rise.

In fact, it appears as if most within the market are looking towards the European Central Bank to undertake most of the market moving machinations in the weeks ahead. Subsequently, much of the rhetoric emanating from the Federal Reserve on rate hikes has done little to impact the Euro whilst largely depressing the US Dollar (part of the ongoing currency wars). In addition, whilst the Fed is largely expected to sit in their hands in the coming months, in contrast the ECB is ready to step up their government bond purchasing program to €80bn a month. Such is the gap of the current policy divide between the respective banks.

However, the issue posing the biggest risk to the Euro is not the monetary policy divide, but one of political turmoil within the EU that is currently going unchecked. The past few weeks have seen the Euro beset with a range of political machinations that appear to threaten the currencies bullish path.

BREXIT Risks

Primarily, there are some very real concerns over the prospect of a Europe without Great Britain as well as the inherent instability that a BREXIT could cause the common currency. Although a decision to “exit” would largely disadvantage Britain, the EU would likely suffer much of the same fate. In fact, any such decision could spur on a wave of negative sentiment as the market attempts to weigh the risk of further member state exits. Subsequently, a BREXIT is likely to play out poorly for all parties equally.

However, just as problematic would be a vote to stay within the Eurozone which would likely lead to the BoE revising upward their growth and subsequent tightening schedule. This could potentially mean that FX markets would need to enter a catch up phase that could see the Sterling rise by over 15% in the medium term.

GREXIT

In extension to the talk swirling about a BREXIT, it would appear that the risk of further complications within the Greek bailout program is increasing. Recent news of tensions amongst the IMF and Germany has rekindled concerns that the embattled Hellenic state could again run close to defaulting on an ECB redemption due in July. The €2.2 billion payment is likely to again stretch Greek coffers, and increased risk has seen the IMF calling for debt relief. In addition, the institution has continued to question its participation in the program without a realistic plan of debt relief in place.

However, the political realities of debt relief for Greece are stark and Germany is unlikely to step back from their line in the sand. Subsequently, as the deadline nears, the risks of default increase and the fractious politics of the Eurozone could drive investors further away from the Euro.

Ultimately, given the range of rising political discourse within the EEC you would expect these risks to be priced into Euro valuations. Unfortunately, this currently isn’t the case and markets have been largely focused upon the shell game that is the US Federal Reserve, instead of the main event, Europe.

Subsequently, consider the Long Euro position to be a fundamentally flawed prospect in the long term given the mounting political risks. As we move closer towards the respective events, expect to see the common currency under pressure as risk is again appropriately priced in. Although the markets current focus is towards the US Dollar, look towards Europe to break the status quo in the months to come.