Pre-Mortem: How EUR/USD Gets to 0.80

A post-mortem is done after an event. It aims to discover what caused the event – for example, in a medical context, it is done after someone’s death. In contrast, a pre-mortem assumes a future outcome, then works backwards to find out what could have led to that event. It is a framing device that allows you to better understand how a particular scenario might unfold. It tends to be much more effective than laying out a base case and risks around it, since the risk scenarios are often an afterthought.

Given the euro’s recent decline to parity, a pre-mortem on the euro could be useful. After all, most analysts have simply taken that breach as opening up the risk of a move to 0.95 – a classic case of chasing the market and lacking an imagination as to what could happen. The more interesting case would be a drop to the 2000 low of 0.82, or even 0.80 (Chart 1).

For that, we can conduct our pre-mortem. The future event would be the euro trading at 0.80 in the summer of 2023 (next year). The question is, what series of events would get us there? That is our pre-mortem.

Back to the Future

It is summer 2023. A heatwave even larger than that of summer 2022 is hitting Europe. As national governments deal with forest fires and a surge in heat-related deaths, the ECB has convened an emergency meeting to discuss the collapse of the euro to 0.80. Few had anticipated that move. But in hindsight, the cause was clear. The breach of parity a year earlier in 2022 was the first sign. Then a series of unfortunate events made it almost inevitable the euro would fall further. Here is what happened.

Relative Monetary Policy

Fed Chair Jerome Powell (ever the canny operator) was desperate not to go down in history as the new Arthur Burns – the Fed chair of the 1970s held responsible for the rampant inflation of that decade. After falling behind the curve in 2021, the Fed had kickstarted its hiking campaign in March 2022. As inflation continued to rise along with public unrest around inflation, the Fed surprised the market in June 2022 with a 75bps hike. Markets continued to think the Fed lacked the resolve to take interest rates into positive real territory. But during the rest of 2022 and early 2023, the Fed ended up hiking rates to 7% (Chart 2). Powell was following the Volker path rather than the Burns path – better a recession than a decade of inflation, the thinking went.

Meanwhile, the usually hawkish ECB was underplaying the rampant inflation in the euro area. Even the Bundesbank was remarkably silent. After all, a larger perceived threat was on the horizon: the end of cheap energy from Russia. The ECB was more worried about managing a recession or even a sudden energy stoppage than inflation. It ended up hiking rates back to 0%. But after that, it was only a few paltry 25bps hikes by early 2023.

This led to an interest rate differential between the US and the euro area of 4-6% – levels associated with FX carry trades. So not only did the US have a hawkish central bank, and the euro area a dovish one, but investors piled into dollars by borrowing in euros. It was a re-run of the USD/JPY carry trade of the 1990s but now in EUR/USD. The drop to 0.80 was almost inevitable.

Political Crisis

Since the Global Financial Crisis, political crises had plagued the euro area. First it was the sovereign crisis and who would underwrite national debt – mercantile Germany or credit-hungry southern Europe. Then it was the migrant crisis of 2015 and the return of national borders. But the Russian invasion of Ukraine in 2022 set a new path for crisis.

Skyrocketing energy prices saw euro-area member countries abandon EU energy rules and start to set price caps and nationalise domestic energy companies. Then some countries wanted to cut side-deals with Russia, while others like Germany were unwilling to abandon Russian gas imports. The solidarity of COVID and the early days of the Russian invasion was gone, and the willingness to provide additional EU subsidies for energy costs dwindled fast. It was each country for itself. With the ECB unwilling to articulate a clear anti-fragmentation framework, Italian and other southern European country spreads started to blow out (Chart 3). Not only that, but the outright levels of yields brought into question the sustainability of debt in the euro area.

Unlike the earlier sovereign crisis, the ECB was unable to unequivocally backstop the system. After all, inflation was rampant, so raising rates and engaging quantitative easing created a dissonance that did not exist before. Moreover, there was no consensus in Germany on what to do: stick to fiscal rules or not, use nuclear instead of Russian gas, and so on. The turmoil turbocharged weakness in the euro.

Current Account

To make matters worse, the euro area’s saving grace, at least from a currency perspective, the trade account surplus, had disappeared (Chart 4). A massive energy import bill had tipped it into deficit, and the weakness in exports to China kept it there. It was unfortunate for the euro area that just as it faced an energy crisis, China itself was undergoing a growth crisis.

The credit binge of earlier years had come home to roost, with the property sector groaning under high debt. The usual growth lever of housing was therefore compromised. Meanwhile, China’s zero-COVID strategy had steadily eroded domestic demand. The only source of demand was periodic bouts of infrastructure spending and export demand. But the former was a shadow of earlier booms, and the latter was hit by a Fed-induced US slowdown.

The euro-area current account therefore remained in deficit thanks to the ends of cheap Russian energy and booming Chinese demand. The Germanic experiment in an energy-intensive trade growth model was finally put to rest.

The End Game

The euro plunged to 0.80 by summer 2023 – the Euro-area was a trade account deficit region, with low interest rates and in political turmoil. The emergency ECB meeting resulted in a call with EU finance ministers and a decision to start a currency intervention programme. It had eventually worked in 2000; the hope was it would work again.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)