Credit Agricole
Assessing the short-term EUR/USD risks
The near-term outlook for EUR/USD tends to be dominated by the EUR-USD short-term rate spread, the peripheral yield spread to Bunds as well as the EUR/USD box yield spread and the performance of the Eurozone stock market relative to the US. We therefore assess the magnitude of the potential EUR/USD downside risks in the short term, related to the brewing energy crisis in Europe, using our FAST FX fair value model.
Assumptions: We make the following assumptions about the EUR-USD short-term rate spread, peripheral yield spread to Bunds and other FX drivers:
1. EUR-USD rate spread
We assume that the ECB tightening cycle would be cut short by the brewing energy crisis and a potential Eurozone recession so that the Eurozone policy rates peak at around 1% or more than 50bp below the current market rate expectations. At the same time, we assume that the Fed would be able to deliver a total of 3.75% of policy rate hikes. In terms of the FAST FX model, we assume that 2Y EUR-USD rate spread would revisit its previous lows of around -2.8% to -3.0%
2. Peripheral yield spread to Bunds
We assume that the combination of persistent Italian political risks and Eurozone growth fears could fuel further widening of the peripheral yield spreads to Bunds. In that, we think that the ECB anti-fragmentation may not work as well to contain the sell-off (at least initially). Moreover, it stands to reason that a second NGEU package may be needed to see calm returning to the Eurozone periphery. In terms of the FAST FX model, we assume that 10Y peripheral yield spread to Bunds can revisit its previous highs of c.3%.
3. Box yield spread between EU and US stock-markets
We assume that the EUR-USD box yield spread and the ratio between the Eurozone and the US stock markets will deteriorate from their current levels. In particular, we assume that they will meet levels last reached before the pre-pandemic period. It should be mentioned that these variables have tended to be less significant drivers of EUR/USD historically so that the impact on our estimates has been somewhat less significant.
The results from the simulation based on the above assumption suggest that the EUR/USD fair value can drop to 0.96 if the energy crisis in Europe cuts short the ECB’s tightening cycle from here while triggering a renewed turmoil in the Eurozone periphery, however. Should the ECB tightening cycle come to an end even earlier or if the sell-off in the periphery intensifies beyond our expectations, EUR/USD could experience even greater downside risks.
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