When it comes to market volatility, summer is often synonymous with a certain degree of calm. If we look at the main currency pairs over the last five sessions, we notice that the fluctuation range has remained very low. Around 100 points for the euro versus the US dollar (EUR/USD), to be precise, with a 150-point range for the euro-Japanese yen pair (EUR/JPY) and a 200-point range for the euro versus the Canadian dollar (EUR/CAD). Market volatility hasn’t quite dipped to the unusually low levels observed at the end of 2019, but it’s safe to say we have entered the summer period.
Risks remain, however, and while the market appears somewhat oblivious to them for now, there are actually quite a few to consider. Among them, persistent tensions between India and China, which has caused New Delhi to adopt protectionist policy with regard to Chinese business activity, as well as continued tensions in Hong Kong, which not only concerns China, but also Europe, the United States and many others. In addition, we are witnessing the emergence of renewed antagonism between Turkey and the European Union on the subject of Turkish naval intrusion into Cypriot territorial waters.
In truth, the foreign exchange market’s muted response may be explained, to some extent, by cashflow injections enacted by central banks over the past three months. This has had a numbing effect on market operators. As long as central banks are ready and willing to intervene, risk perception will diminish. Though it is perhaps an understatement to say so, they have perfectly fulfilled this mission until now, which has led to a ballooning of their balance sheets. To this end, the balance sheet of the Bank of England (BoE) as a percentage of GDP now finds itself at its highest level since… 1700! That of the European Central Bank (ECB) currently represents 50% of euro zone GDP, and this figure should climb to 61% by the end of this year. Japan remains the ultimate record-holder, however, with a central bank currently representing 117% of GDP. This is expected to rise to 125% before year end.
Indeed, central bank interventions have been able to stave off a potential liquidity crisis, thus avoiding a scenario similar to that of 2007-08. That said, it remains unclear whether they can do much to placate the second wave of economic challenges on the horizon. These instances may yet shake up financial markets, with the currency market being no exception. If it were to occur, an upset of this kind may be expected by September at the latest.
The factors potentially resulting in greater instability and volatility are numerous. They include:
- An increase in bankruptcies, which is likely to occur more or less everywhere, especially in southern Europe, where economies are highly exposed to tourism (in some cases representing up to 20% of direct contribution to GDP). In the medium term, this may serve to deepen Europe’s north-south divide and work to the euro’s disadvantage.
- A banking crisis may also be imminent. Viktor Constancio, one of the ECB’s most distinguished former members, broached the topic last week. As he pointed out, banks are going to find themselves in a critical position, given the massive increase in non-performing loans, for which interest payments have ceased over the past 90 days. To this end, we cannot rule out the occurrence of another banking crisis in the euro zone in the second half of this year, or at the beginning of 2021 at the latest. This would come in spite of measures implemented following the 2012 crisis, in particular the banking union mechanism.
- The US presidential election will also be a factor. Though it has remained somewhat of a nonentity for the time being as far as the currency market is concerned, the November elections are likely to become an important consideration sooner rather than later. It is too early to predict which candidate will emerge victorious, but one thing is clear, whether Donald Trump or Joe Biden find themselves in The White House for a four-year term, tensions with China look set to increase.
With all this in mind, we maintain a bearish bias on the EUR/USD in the medium term, while considering the psychological threshold of 1.10, which has already been reached on no less than four occasions since the beginning of this year. If this level were to be reached once more, we might expect the pair to dip lower still, reaching the 1.08 mark.
Presentation of a newly compromised version of the European recovery plan, “Next Generation EU”
US Non-manufacturing PMI for the month of June
JOLTS report on US employment for the month of May
US producer price index for June.