The euro was comfortably trading above $1.20 for a short time earlier in the year.
Investors talked up Europe’s plans for defence expenditure, large-scale infrastructure projects and an improved post-pandemic economy.
This optimism vanished almost instantly. Energy dependence, one of Europe’s most ancient vulnerabilities, was revived by the war in the Middle East.
In just a matter of days, crude oil prices soared past $100 per barrel. Natural gas also rose.
This episode brought to traders’ attention a truth that is easily overlooked in markets with calmer conditions — the first thing to go when energy costs rise is usually the euro.
What makes energy more expensive?
The impact of energy shocks on economies is different, but for Europe they are felt through the balance of trade. Most of the gas and oil that is consumed in Europe comes from abroad.
If global prices rise, the region will need to sell more Euros in order to purchase dollars.
US is one of world’s biggest energy producers, and exporter. But they feel the pain in a different way.
The higher commodity prices increase export revenue, even though they also squeeze the external balance of Europe.
This divergence is evident in the market for currencies. Barclays believes that a 10% increase in oil prices will tend to boost the dollar’s value by 0.5%-1% against other major currencies.
The euro can be reduced by 0.25% with a similar increase in gasoline prices.
The pattern has almost played out as scripted.
Since tensions flared up in the Middle East oil prices have risen by more than 15 percent, and benchmark European gas has briefly doubled.
Already, the euro is down around 2% compared to the dollar.
The logic for traders is straightforward: as energy prices rise, Europe’s surplus trade shrinks, and the euro adapts.
Once the trade balance protected euro
It was supported by an important structural advantage for much of the history of the Euro – a constant current account surplus based on the export of automobiles, machines and industrial products.
Even during times of turmoil in the financial markets, Europe’s export machines created natural demand for euro.
This buffer is undermined by energy shocks. Gas prices spiked in 2022 after Russia invaded Ukraine. The trade surplus disappeared and the euro fell below parity against the dollar for first time since the 1990s.
Although the current situation may be less serious, the mechanism remains the same. The rising cost of oil and gas increases Europe’s import bills and diverts income overseas.
George Saravelos, a Deutsche Bank analyst, calls the “tax” imposed on European economies – a tax that is paid to energy companies abroad in dollars.
It’s because of this that the FX market moves so fast when energy prices rise. The trade balance follows.
The ECB dilemma
The European Central Bank is in a difficult position after the latest energy crisis.
Energy-driven increases in prices are not the same as demand-led inflation. The increase in consumer prices is accompanied by a slowdown of growth.
Eurozone is now facing the same tricky situation — inflationary pressures with no real acceleration.
The markets have shifted their expectations about how long the ECB will hold its rates. Policymakers are once again forced to defend price stability while having one hand tied behind their back.
The traders had been expecting rate reductions later in the year. The futures market now prices the possibility that rates could rise as soon as July.
The ECB’s difficult balancing act
Even higher rates of interest may not solve the problem.
According to the European Central Bank, this year’s eurozone economic growth will be around 1.2%. This forecast is based on increased household spending and more favourable financing conditions. Both are threatened by rising energy prices.
According to Marcus Ashworth, a columnist for Bloomberg Opinion who wrote recently about the issue, stricter policies could undermine rather than support the euro.
The higher borrowing costs could worsen the slowdown in growth without reducing the impact of the energy price inflation.
This leaves policymakers trapped between the market’s expectations and an unstable recovery.
Investors expect the ECB’s response to the rising inflation rate, but it is possible that the economy will not be able to take another blow.
The dollar is still winning
When uncertainty increases, the demand for dollar dollars is unabated.
Dollar assets are typically sought by investors during times of geopolitical and market tension.
The energy markets reinforce this bias. Because oil and gas are still traded in dollars, the demand for this currency increases when prices rise.
The funding markets are under pressure: the demand for dollars through currency swaps is up as foreign institutions rush to gain access.
Investors tend to keep their exposure to the dollar even when U.S. Treasuries or stocks are in turmoil. Analysts at Societe Generale recently noted that the markets are more inclined to hold the dollar in this current environment than they are the euro.
The proximity of geopolitical regions only strengthens this preference.
The US appears to be relatively insulated, while Europe is closer to the most recent conflict zones and more vulnerable to its economic impact. The currency traders responded in kind.
Energy dependence and its price
Underneath daily changes in the market lies a more fundamental structural issue. Europe is still one of the largest energy consumers in the world.
The domestic production of nuclear power has declined in many key economies.
This combination of factors makes this region extremely sensitive to the cost of energy.
Gas and electricity price spikes can affect industries that use a lot of power, from steel to chemicals. This will reduce their margins and slow down production.
Investors are vulnerable to FX market volatility.
The euro is a gauge for energy strain in real time. Energy shocks have a greater impact on Europe’s economic growth than any other large economy.
What are the traders watching?
The currency desks have become fixated with several metrics which often predict big movements in the euro.
Since the crisis of 2022, European gas prices have been a key indicator. Sharp increases are often accompanied by a tightening up in power and industrial production.
The price of oil is also crucial.
Analysts believe that an increase of 10% in Brent crude oil can cause the euro to weaken by 0.8% when compared with the dollar.
Gas storage levels in Europe is another important variable. Low gas stocks heading into the winter can cause a spike and affect FX forecasts.
The euro is currently hovering around $1.15.
Some analysts expect the market to stabilise if oil prices drop and tensions do not increase in the Middle East.
Some analysts predict further declines to the range of $1.10-$1.12 if oil prices remain high and gas markets continue tightening.
When energy prices rise, currency markets tend to react first.
The post Why Europe’s energy bills is crushing the euro and driving dollar demand can be modified as updates unfold. This post may change as new information becomes available
