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Euro at Risk of Falling Towards $1 as Resurgent Oil Prices and Italy’s Fiscal Concerns Weigh

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Euro Faces Headwinds as Resurgent Oil Prices and Italian Fiscal Concerns Weigh

The euro is facing increasing challenges as resurgent oil prices and worries about Italy’s fiscal position put pressure on the currency. With the euro trading at its lowest levels of the year near $1.05, there are concerns that it could move closer to the psychologically significant $1 mark.

The euro has already seen a 3% decline against the dollar in the third quarter and is on track for a third consecutive year of losses. While the strength of the US economy and the influx of cash from abroad have contributed to the euro’s decline, there are also euro-specific factors at play.

One of these factors is the euro area’s exposure to higher oil prices. The European Union relies on net imports for over 90% of its oil products, making the euro particularly vulnerable to rising oil prices. “High oil prices are weighing on the euro area’s terms of trade, and if oil prices move above $100 per barrel to $110 per barrel we think it will be difficult for the euro to avoid parity,” said Jordan Rochester, G10 foreign exchange strategist at Nomura.

Oil prices have surged nearly 30% in the last quarter alone, reaching almost $98 per barrel last week. This increase in prices is due to efforts by the Organization of the Petroleum Exporting Countries (OPEC) and its allies to limit crude supply. Barclays and other banks expect oil prices to continue rising, potentially reaching $100 in the coming months.

Given these factors, Nomura predicts that the euro will weaken to $1.02 by the end of the year, suggesting a further 3% fall from its current levels. Morgan Stanley also expects a further weakening of the euro, with Chief Europe Economist Jens Eisenschmidt stating that the euro area is more exposed to energy shocks and geopolitical risks than the United States.

While a weak euro can benefit exporters by boosting their competitiveness, it also leads to higher import costs and increased price pressures. This compounds the impact of higher oil prices and could require the European Central Bank (ECB) to pay more attention to the situation.

The recent performance of the euro on the trade-weighted index, closely followed by the ECB, shows a decline of just 0.9% in the last quarter and a roughly 2% increase compared to the end of 2022. However, when the euro reached parity against the dollar last year, the ECB expressed concerns about its impact on inflation without targeting a specific level.

Another concern for the euro is Italy. The yield premium on Italian debt, compared to German debt, reached 200 basis points last week, a level that typically corresponds with a correlation between the premium and the euro. ING currency strategist Francesco Pesole warns that if the Italian bond market deteriorates significantly and the ECB does not take swift action to calm investors, the euro could face downside risks and move towards the $1.00/$1.02 area. Pesole also notes that solid US data and a hawkish Federal Reserve are important factors to consider.

Despite these challenges, the weakness of the euro could be limited if the US economy slows down along with inflation. Athanasios Vamvakidis, global head of G10 FX strategy at Bank of America, suggests that if there is a combination of higher US unemployment and lower inflation, it could be negative for the dollar. However, he acknowledges that there is a risk of the euro reaching parity if the US economy weakens but inflation remains sticky.

Looking ahead, there are further obstacles for the euro. Investors have maintained long positions on the euro for some time, with latest positioning data showing a net long position worth $13 billion. If these positions are unwound, it could exacerbate the downward momentum of the euro. Additionally, the boost from higher interest rates, which the ECB had been implementing, has faded as the central bank signals the end of its aggressive tightening cycle.

Overall, the euro is facing headwinds from various factors, including resurgent oil prices and concerns about Italy’s fiscal position. While a weak euro can benefit exporters, it also brings increased import costs and price pressures. The euro’s performance in the coming months will depend on a range of factors, including the strength of the US economy and inflation levels.

More detail via BusinessWorld here… ( Image via BusinessWorld )

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