The most liquid market in the world, EURUSD, has been the center of attention of the past week or so. Although not my market of choice, it does overshadow all of the markets I do trade. It is no secret Bitcoin, and most of crypto, is correlated with the almighty DXY.

The dollar has been very strong over the past year or so, as risk assets sell off there is an enormous amount of wealth looking for the exit. But in particularly the EUR/USD has been interesting as it has been rapidly approaching that magically 1.0000 price level. Although I’m not an expert on the FX markets, I will try to elaborate my view on this and how this will unfold in the coming months/years.

What is going on

As I see it there are three major reasons why EURUSD is falling.

  1. European trade deficit
  2. Monetary policy
  3. Strong dollar

European trade deficit

Think about a sovereign country buying natural resources like oil or gas from another country. One country is printing dollars, rubbles or rupees out of thin air. It takes some serious convincing for a country to give up billions of dollars worth of actual useful goods for some printed paper. Not too long ago most currencies were directly or indirectly pegged to gold, this gave the sovereign debt some credibility. If you had no use for the printed paper your neighbor gave you, you could redeem it for gold.

Nowadays these currencies are floating. Meaning that the only thing that gives it value, is what someone else will give you for it. The emphasis on what is important here, usually we are talking about how many dollars someone will give for your euro. But why would he give you dollars for this European debt? The value of the euro on the global markets is directly linked to what one can buy with those euros. This means the EU needs to run a reasonable balance of trade for the euro to be valuable globally.

Imagine for a second you are a sovereign nation outside the EU trading with European countries. You sell barrels of oil to Europe for euros. Then with these euros you can buy yourself some fancy German cars. If the EU is running too much of a deficit, for every $100 of oil you sell to Europe, you are only getting say $80 of cars back. Unless you really fancy a new Audi, that is not sustainable. This will mean you are going to charge more euros for your oil, effectively lowering the price of the euro.

Now let me show you a chart of the EU’s balance of trade. (exports – imports)

Now this data is very noisy, but the picture is clear. Europe exports are collapsing. Granted, this is only ~1.5% of the total imports/exports, but that is not looking great.

Monetary policy

In crypto we love to keep our eyes peeled to every fed’s move. However, the European Central Bank has definitely not been keeping up. Where the FED has been hiking slowly up to 1.5%, and with probably another 75 or even a 100 bps hike coming up, the ECB has been seriously slacking. After the FED had done multiple hikes, the ECB followed with a measly 50bps. Adding on to the fact that the ECB rates were already lower at -0.5%, this is extremely dovish. Lets see what the effect of this policy was.

This is Italy’s debt multiplied by their 10 year bond yield. This would be their yearly interest payment on their current government debt if they were to refinance now. Yikes! And remember, the ECB didnt even really start hiking yet. This is mostly speculation on future hikes. Now for everyone reading I think it is obvious 90Bn euros a year in just interest is a lot of money. But how does this compare to a healthy european country? Lets compare to Germany.
Still quite the run up from receiving 10Bn a year in interest to having to pay 26bn. However, remember that Germany’s GDP is more than twice that of Italy, and its rent payment is a third.

Italy’s, and many other southern European countries are absolutely riddled with debt. If the ECB where to actual have some balls and proceed with serious interest rate hikes, half of Europe would default. Current rates are already crippling for Italy’s economy, and we are still at negative rates!

Strong dollar

With the bear market now here for multiple months, we are seeing some heavy selling of risk assets. A lot of these assets are sold into USD, even if the original purchase was not necessarily in USD. In crypto most people are selling into dollar stables, even outside of the US. Combine that with the dollar having rate hikes, and starting to have relatively attractive yields around 4% again, it is very tempting to hold the dollars. Pay interest at the bank or at your eu broker account, or make 4% yield on a stronger currency..

What now?

So looking at these three aspects, it is not looking good for the euro. But can we speculate on how this will evolve? Lets go through the three reasons one for one.

Trade deficit

First off, the trade deficit. There are two ways to combat this, either Europe has to dial down their standards of living and reduce their imports, or they could try to bump their exports to match their expenses. Lets assume the first one is a big no-no, and take a look at the biggest exporters of the EU and how they are going to fare in the future.

The biggest EU exporter is Germany, obviously. They have been in the news for their massive energy problems. They are mainly exporting industry products, machines and automotive products. Guess what this industry needs? A lot of energy. With energy prices ballooning all across Europe, price of their exports is not going down anytime soon.

How about the rest of Europe? Well the second largest exporter is The Netherlands. Slightly surprising maybe, one would have expected France or maybe some large southern country like Italy or Spain. No it turns out the Dutch are very good at exporting, their biggest export is machinery and automotive industry. In particular companies like ASML are exporting a lot, which is only going to get bigger in our technology-driven world with a chip shortage. However, there are already talks of banning these high tech exports to china, which might limit the growth potential of these exports.

The Netherlands is also a beast in agriculture exports, the second biggest exporter in the world. At over a 100bn euro of export, this is absolutely insane for a country of such size. The biggest contributor is of course their beautiful flowers. But their second and third biggest category is meat and diary products, totaling 20bn in exports. This, however, is about the change. Currently there are talks in the Netherlands to half its meat production, and weirdly enough one of the arguments is that most of it is exported anyways. It seems very likely that the agriculture sector is going to be slashed, if the plans continue as is, we’d see at least a 10bn reduction in exports. This very specific dutch issue would increase the trade deficit of the entire eu from 30bn to at least 40bn, maybe even 50bn.

In short, the trade deficit is going to be a tough battle.

Monetary policy

We already mostly discussed this in the chapter above. I’m going to be very blunt, the ECB can not practice effective monetary policy without risking destroying the union. Countries like Italy can absolute not withstand any serious rate hike. Current rates are already going to be very tough when they eventually have to refinance their debt. Maybe the ECB (and with that the rest of the union) could buy up all their debt and try to clean their slate. However, currently they already run a 10-30% budget deficit, meaning they are spending more than they have in income. So they’d have to reduce their spending, in combination with the largest European bail out ever.

Strong dollar

This really is the only reasonable way out of this mess. The American FED could come to the rescue. They are well known for buying up domestic bonds, but their power is not limited to the USA. They could print more dollars to buy up the bonds of their European friends. This would devalue the dollar, and in turn strengthen the euro. Paradoxically this could be a win for the US too, currently their export is hurting, and this would help cheapen their export. However, it would be a tough sell to the US public, weaken the national currency to help the Europeans.. Its going to play right into the ‘America first’ playbook of the republicans. I’m not convinced the democrats are willing to risk the next elections on this.

This concludes my thoughts on the EUR/USD for now. For now I remain bearish on EUR, as I don’t believe the EU can get out of this mess on their own. However, some big news like the FED buying up euro bonds could drastically change the course. It seems like the magical 1.00 level has been saved, for now.