Euro-Dollar Rate Lags Wednesday, but Holds Advantage in Race to Economic Recovery 

- EUR underperforms as China tensions rise over Hong Kong.
- Is vulnerable in international spat on EU-CN trade linkages.
- But with upside risks as Germany winning in race to recovery. 

© European Union

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The Euro was trading lower against the Dollar Wednesday as price action took a cautious turn amid international condemnation of China's actions in Hong Kong but the downside may be limited because the single currency holds an advantage over the Dollar in the race to economic recovery. 

Europe's unified unit was trading lower against half its major rivals including Sterling on Wednesday as stock markets and currencies took a risk-averse turn into the North American open, with safe-havens like the Japanese Yen outperforming underperforming. 

The Euro has underperformed since late in the Tuesday session when it became clear China had passed and was imposing a controversial 'national security law' on Hong Kong that's believed to violate the 'one country, two systems' model for governing the city.

It follows years of pro-democracy protests that have angered Beijing.

“The enactment and imposition of this National Security law constitutes a clear and serious breach of the sino-British joint declaration," says Prime Minister Boris Johnson, in an address to parliament.

"If China and markets are right and the US does not have the stomach for real action on Hong Kong, risk remains ’on’. As with Brexit, actions we were repeatedly told could never, would never happen are absolutely fine and life just carries on (i.e., stocks go up.) Yet as geostrategists point out, so does the real-world risk that the next US-China clash will be over Taiwan," says Michael Every, a Hong Kong-based strategist at Rabobank. "If China and markets are wrong and the US does have the stomach for real action on Hong Kong, risk will be ‘off’: and all the central bank action in the world is not going to suppress that particular bout of volatility. In short, risks remain either way."

Above: Euro-to-Dollar rate at daily intervals, divering from the risk and commodity sensitive New Zealand Dollar. 

Chinese economic linkages run deep into Europe's powerhouse industrial economies as was demonstrated in the two years to 2020 when the bloc suffered more from the U.S.-China trade war than either protagonist.

Fears of the response and a tit-for-tat exchange of actions between the U.S. and China including the designation of media outlets as 'foreign missions' are reflective of rising tensions between China and others in the world. 

"The law also applies to everyone everywhere in the world. This means if one were to be seen by Beijing as breaking this new legislation in another country and then enter Hong Kong, or transit through it, or even fly in a vehicle registered in Hong Kong, then one would be at risk. Possibly this could even apply to those residing in a country with an extradition treaty with Hong Kong (or one day China?). In short, it is a very large, sharp Sword of Damocles. As such, the same Sword now hangs over markets too," Every says.

The White House has repeatedly threatened retaliation in the event China passes the national security law, while German Chancellor Angela Merkel said Wednesday she will push for a UN Security Council debate on human rights in China. But the U.S. is yet to say exactly what its response will be while China is a permanent member of the UN Security Council so can veto its resolutions. 

Above: Euro-to-Dollar rate at weekly intervals with 200-week moving-average in green.

"The risk of market downturn is not negligible due to the strong disconnection between the market and the real economy and trade skirmish between the United States and China following the passing of the Hong Kong's security law this week," says Christopher Dembik, head of macro analysis at Saxo Bank

Europe's single currency was falling on Wednesday but if an increase in hostilities between China and other countries can be avoided over the coming weeks, the Euro could find itself receiving a bid at least in relation to the Dollar.

"It's impossible to have a ‘good' pandemic, but Angela Merkel's doing pretty well," says Kit Juckes, chief FX strategist at Societe Generale. "SG Economics have been telling me for weeks now, the consensus is wrong to believe that Europe will be hit harder than others...surely there's a serious risk that we see US growth forecasts edge lower while Germany drags the rest of Europe up in the weeks ahead? All the more so if progress is seen in developing more activist European fiscal policies." 

Germany's economy shrank less in the first quarter than major counterparts and at less than half the pace of decline seen in the U.S., while also being thought to have been impacted less by coronavirus containment measures in the second quarter. Differentials in expectations for growth matter to exchange rates and could be key to whether the Euro-to-Dollar rate bests its June high just above 1.14 or slips back below that month's floor around 1.11. 

The Transatlantic differential was moving in favour of the Euro Wednesday after Destatis said German retail sales rose 13.9%, blowing economist expectations for only a 3.5% gain clear out of the water. It remains to be seen if other Eurozone economies will also follow along the same path to a robust recovery although if economists become convinced that they will, the Euro-to-Dollar rate would likely benefit because it tends to follow the differential between expectations for growth in Europe and the U.S.

However, and in the very short-term at least, geopolitical tensions and the July European Council meeting could dominate price action. The July 18-to-18 summit will see leaders attempt to agree terms of a coronavirus recovery fund, the proposal of which was key to lifting the Euro back above 1.10 in May.

"EUR/USD will remain entrenched within a 1.1150‑1.1400 range at least until the 17‑18 July EU summit where EU leaders will try to push forward the proposed €750bn EU‑wide recovery fund," says Elias Haddad, a strategist at Commonwealth Bank of Australia

Above: Societe Generale graph showing changes in retail sales for UK, U.S. and Germany. 


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