The euro area constitutional challenges and potential revival of US-China tensions: FX implications and risks

EURUSD: We turn neutral

A recap of our EURUSD view held so far: We have held a constructive view on EURUSD so far, on account of already significant undervaluation that has been considerably exacerbated by US Federal Reserve (Fed) actions (bringing rates to near zero and expanding its balance sheet significantly). EURUSD is now undervalued by 9% on a long-term basis on our estimates. At the same time, we argued that the EUR ascent would be gradual, as the dollar would likely continue to incorporate a risk premium associated with the Covid-19 pandemic and the global growth slump, especially during H1 2020.

What has changed?

We highlighted that one of the risks to this constructive view related to the possibility of the EU failing to come up with a convincing coordinated fiscal plan to stem off the pandemic crisis (namely, the timely agreement and implementation of a recovery fund). Although progress is still lacking on that front, a significant new risk has arisen. On 5 May, the German Federal Constitutional court (GCC) issued a rather mixed ruling on the European Central Bank (ECB)’s QE programme – relating to the Public Sector Purchase Programme (PSPP) but not – or not yet – to the recently established Pandemic Emergency Purchase Programme (PEPP). The court accepted that the ECB’s QE programme did not violate the prohibition of monetary financing of member states, in line with the ruling of the European Court of Justice (ECJ). It did, however, rule that the German central bank (Bundesbank) may no longer be allowed to participate in the PSPP unless the ECB demonstrates that “the monetary policy objectives are not disproportionate to the fiscal and economic policy effects of the programme”. The court gave the ECB three months to respond in order to resolve the situation.

We see this as creating headwinds for the EUR. Namely:

1. It undermines investors’ (already fragile) confidence in the euro-area project, its cohesion, and EU rule of law. Effectively, the German court has “crossed the Rubicon” by rejecting the ruling of the ECJ, the institution responsible for interpreting EU law. The ECB said that it took note of the German court ruling but, at the same time, highlighted the December 2018 ECJ decision that found the central bank was acting within its monetary policy mandate. ECB President Christine Lagarde reiterated the bank’s independence, adding that the institution answers directly to the European Parliament. A full-blown constitutional crisis is still not the most likely outcome (see below). However, this legal “assault” (by an institution, by nature agnostic of capital markets’ functioning, and having no jurisdiction over the ECB) risks creating confusion and depressing market sentiment towards the common currency.
2. Moreover, the possibility of the Bundesbank not participating in the PSPP or even selling (albeit gradually) its public sector debt holdings (i.e. those of Germany) could imply that euro-area periphery spreads (notably those of Italy) remain elevated.

All this does not necessarily mean that EURUSD is about to collapse. First, other forces are likely to prove supportive (dislocation from yield differentials; a very strong euro-area current account surplus, as well as individual member states’ fiscal response to the Covid-19 crisis). Second, although the ECB may not respond directly to the German court request (to avoid setting a precedent), the Bundesbank should be able to provide a satisfactory justification and thus avoid a full-blown constitutional crisis. Nonetheless, some sort of near-term damage has been done. In principle, we do not doubt the ECB’s resolve to expand its PEPP further amidst the virus-related risks, but there is now a higher risk that the German court ruling could affect future decisions on the size and composition of additional asset purchases. Moreover, the move has set a precedent that increases the risk of similar legal battles between national courts and their national central banks across member states. Finally, it is possible that the decision could pave the way for the PEPP to come under similar legal scrutiny.

All this means that there is now a higher risk premium embedded in the euro, and that the bar for significant appreciation has risen. Consequently, we turn neutral. We cut our forecasts to 1.09 for H1 2020 and to 1.11 for the end of the year. We allow for some very small appreciation mainly due to the broader USD downside we envisage for H2 2020.

What could see us turn EURUSD-constructive again? We will be closely monitoring developments relating to the German court ruling and whether the Bundesbank – which now appears to have an increased role in the situation – responds as a pressure relief valve. Additionally and importantly, it is possible that this development will force EU leaders to expedite their agreement of a substantial and coordinated fiscal support package (recovery fund). In such a scenario, we think that headwinds would abate, and we would again turn constructive on EURUSD.

What could see us turn outright bearish on EURUSD? All other things remaining unchanged (i.e. Fed and ECB monetary policies), either a full-blown EU constitutional crisis and/or a complete failure by the EU to establish a pandemic recovery fund would suggest EURUSD coming under severe downside pressure. A reversal of the improvement seen in the pandemic trend would also be negative for EURUSD.

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