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The Euro is Damned if they Do and Damned if they Don't Reach a U.S.-China Trade Deal 

Image © European Union 2018 - European Parliament, Reproduced Under CC Licensing.

- EUR slips, USD rises, on reports U.S.-China tariffs to come down. 

- Trump-Xi headed for end-March summit to sign a trade peace deal.

- EUR is damned regardless, investors to use as a "funding currency".

The Euro underperformed most G10 rivals in a risk-on market Monday as investors responded to a report from The Wall Street Journal claiming negotiators are close to reaching a deal that ends the U.S.-China trade war, but the single currency could be damned if the talks succeed and damned if they don't.

Europe's single currency is in a mire because investors are once again beginning to view it as a "funding currency" of choice, given the Eurozone's economy is slowing so rapidly the European Central Bank (ECB) has already been knocked off its policy "normalisation" course and there's still a litany of risks lurking on the path up ahead. 

With the ECB's record low interest rates now set to prevail for a while longer, analysts are feeling more confident about advocating that clients use the Euro as tool to fund speculative bets on other assets, which requires them to borrow Euros, sell them on the market and use the proceeds to buy other currencies. 

If this practice continues then it could ensure a steady supply of Euros is drip fed onto the market over the coming weeks and months, which would prevent the single currency from regaining higher ground that was recently lost to the Dollar.

An analyst from Thomson Reuters wrote to subscribers of the firm's professional service Monday explaining why this scenario could still leave the Euro damned. 

"Risk appetite is soaring on the heightened chance that the United States and China will agree a trade deal and lift tariffs underpinning stocks and supporting high yielding currencies. As a result the euro which is the most liquid of any of the popularly used funding currencies, should come under more pressure. The soft euro zone economy is increasing the chance that the European Central Bank adds liquidity at the some stage, and speculation surrounding TLTRO's will boost the risk-on feel in FX markets further weighing on the euro," says Jeremy Boulton, an analyst with Thomson Reuters' dealing room FX community. 

The Wall Street Journal claimed Monday that negotiators are close to finalising a trade deal that could see White House tariffs removed from Chinese goods exported to the U.S., which suported the greenback and prompted a fresh bid for so-called risk assets. 

The paper says that a formal agreement could be signed at a March 27 summit between Presidents Donald Trump and Xi Jingping, but qualified this with a warning stating that "hurdles remain, and each side faces possible resistance at home" due to perceptions on both sides that the terms of the agreement are too favourable for the opposite party. 

Above: Euro-to-Dollar rate shown at daily intervals.

The Euro-to-Dollar rate was -0.19% lower at 1.1342 Monday and has declined -1.07% this year, while the Pound-to-Dollar rate was 0.36% higher at 1.3242 and is up 3.94% for 2019. The Dollar index was 0.20% higher at 96.58 and has gained 0.56% in 2019.

Stock markets closed higher in Asia after a bouyant overnight session, while most European indices were quoted above their Friday closing levels during the morning on Monday. Oil prices were also higher, while yields U.S. and German 10-year yields were lower.  

Above: U.S. Dollar Index (DXY) shown at daily intervals.

The view outlined by Reuters' Boulton on Monday is similar to that put forward by analysts at ING Group, who say an end to the trade war could give the Federal Reserve (Fed) the excuse it needs in order to lift U.S. interest rates this year. That would widen the gap between U.S. and European bond yields, which could heap further downward pressure on the Euro so long as markets see an ECB rate rise as only a distant prospect. 

"The eventual resolution of the trade despite should provide the Fed with the room to hike interest rates in Q3 this year (which is not priced in)," says Petr Krpata, a bond and currency strategist at ING. "Even if the risk environment continues improving, USD should stay supported against low yielders such as EUR and JPY. Particularly for USD/JPY we see more upside ahead given the mix of rising stock markets and scope for higher UST yields."

This leaves the Dollar in a bit of a sweet spot that could ultimately see it remain bid for a while yet, regardless of what happens with China. It could also be said that it leaves the Euro in a situation where it's damned if negotiators do reach a deal, and damned if they don't. That's because the U.S. trade fight with China is one of the key drivers behind the economic slowdown seen on the continent over the last six months. 

Homegrown headwinds such as new regulations that have stymied production in the automotive sector were a big part of last year's economic cooling, but not the only part by any stretch of the imagination.

The European, and particularly German manufacturing sectors, are sensitive to changes in demand from China, whose economy has been hobbled by the trade war with the U.S.. Most economists see growth in the world's second largest economy continuing to decelerate in 2019 even if the trade conflict is brought to an amicable end.  

"The US and China seem to be inching towards an agreement on trade. But while the dampening down of trade tensions between the world's two largest economies would clearly be a positive development, it is unlikely to provide much of a boost to global growth this year. Meanwhile, it seems that most of the good news on trade is now priced into asset markets," says Neil Shearing, chief economist at Capital Economics.

The European Central Bank will, on Thursday, adjust its economic forecasts for 2019 following the latest data and potentiall set out details of any measures it intends to implement in order to support the Eurozone economy this year as it grapples with after effects of the trade war and political headwinds. 

Brexit and the looming European Union parliament elections in May may continue to undermine appetite for the Euro, and Eurozone economic growth, during the months ahead. These will also be key concerns for the ECB, although it might not want to be seen to acknowledge that. 

 

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