EUR/USD at Risk of Seeing German Economic Recovery Snuffed Out by Trade War, ZEW Survey Shows

© The White House 

- EURUSD recovers with risk appetite but ZEW flags trouble ahead.

- Six-month expectations for Germany, Eurozone slide amid trade war.

- Analysts say Euro strength won't last, see fresh losses in days ahead.

The Euro held gains over major rivals Tuesday as risk assets recovered following a milder-than-expected Chinese response to President Donald Trump's trade tariffs, but May's ZEW Institute survey has suggested the German economic recovery is at risk of being snuffed out by the trade war.

May's ZEW German Economic Sentiment index came in at -2.1, down from 3.1 in April, when financial markets had been looking for it to rise to 5.1. This takes the index further below the long-term average of 22.1 and means the six-month outlook has turned for the worse of late.

"“The decline in the ZEW Indicator of Economic Sentiment shows that the financial market experts continue to expect restrained economic growth in Germany for the next six months. The most recent escalation in the trade dispute between the USA and China again increases the uncertainty regarding German exports – a key factor for the growth of the gross domestic product,” says Professor Achim Wambach, president of the ZEW Institute.

These results may come as a disappointment to markets because it was hoped that Germany economy would recover lost economic momentum throughout 2019, and given that the current assessment component of the survey showed current activity picking up in May.

The ZEW survey asks 300 financial analysts various questions relating to the markets and economy. Tuesday's survey was taken between the 06-13 May, which means the responses were influenced by President Donald Trump's second major offensive in the so-called trade war with China.

"The slide in the ZEW investor expectations looks ugly compared to the consensus, but we suspect that this is partly because many forecasts were formed before the most recent volatility in markets, while at least some of the responses were taken last week as the slide began, in response to the escalating trade dispute between China and the U.S," says Claus Vistesen, chief Eurozone economist at Pantheon Macroeconomics. 

Above: ZEW current activity (top) and expectations (bottom) indices.

Tuesday also saw the ZEW survey for the Eurozone released, which suggested that current levels of activity were much higher in early May than they were in April, although expectations for six months ahead turned sharply lower. 

The Eurozone current activity index rose 6.2 points to -7 in May, but the six-month outlook index declined 6.1 points to -1.6. 

"Looking ahead, with global economic growth likely to remain weak this year and next, industrial production across the euro-zone looks set to remain sluggish, weighing on the wider economy. We forecast euro-zone GDP to rise by just 0.8% in 2019 and 2020," says Christina Iacovides at Capital Economics. 

Both German and Eurozone economies were expected to build in the coming months, on economic gains made in the first quarter, after slowing sharply in the second half of 2018. But the outlook is growing much more uncertain.

Eurostat estimates the Eurozone economy grew by 0.4% in the first-quarter, up from 0.2% at the end of 2018, although the initial data for Germany is yet to be released. Regardless, Tuesday's surveys suggest there's a risk that any first quarter recovery may simply be snuffed out again in the second quarter. 

"We think the balance of geopolitical & economic risks favours a move in EURUSD to 1.09 in 3M," says Stephen Gallo, European head of FX strategy at BMO Capital Markets. "We expect EURUSD to retain a “risk discount” out to the 6-9M part of the curve amidst international trade disruptions, Brexit uncertainties and further dovish pivots from the ECB."

Above: EUR/USD rate shown at 4-hour intervals.

The EUR/USD rate was 0.05% higher at 1.1237 following the release but is down -1.9% for 2019. The Euro rose against the Dollar, Yen, Swiss Franc and Pound Tuesday but was lower against most other G10 rivals.

Gains for the Euro came Tuesday as European stock markets rebounded from Monday's losses, while prices of some commodities like oil were also lifted, after China's response to President Donald Trump's latest tariffs was judged by analyst observers as being quite mild. 

"EUR/USD is making a valiant assault at 1.1266 resistance, and is supported by a solid-looking wall at 1.1120," says Kit Juckes, chief FX strategist at Societe Generale. "If you like, you can cite President Trump's optimism that a deal with China can get done as a ‘reason' for the mood to improve but I'm tempted to conclude that the real reason is - it's Tuesday! On which basis, I wouldn't place too much faith that the current mood improvement is going to last all that long. Still, it can certainly last for a day or two."

China raised on Tuesday, the tariff rate levied on most of the $60 bn in annual imports from the U.S. that is has targeted so far in response to President Trump's tariffs. This was after Trump lifted, from 10% to 25%, the tariffs levied on some $200 bn of annual imports into the U.S. 

The White House has now set the ball rolling on a process that could ultimately culminate in another $300 bn of China's annual goods exports to the U.S. being subjected to tariffs of 25%, which risks making Chinese goods uncompetitive relative to alternatives and harming the economy. 

"We’ve just heard Trump reiterate he has an instinct that Chinese trade talks, which aren’t even happening right now, are going to be “very successful.” And, yes, that pivotal meeting with China’s Xi is still to come at the next G-20. But right now the risks are of a broad and dangerous deterioration in US-China relations," says Michael Every, a strategist at Rabobank. 

Above: EUR/USD rate shown at daily intervals.

Tariffs cause economic damage by raising the domestic price of goods imported from another country, which places the imported goods onto a level playing field with those available in the domestic market or makes the imported goods uncompetitive and effectively shuts them out of the market in the process. 

However, if China is going to be hurt in the tariff fight then it won't be long before the fallout hits Europe given the close economic relationship between the two. 

Eurozone GDP growth fell by more than half in the third quarter of 2018, from 0.4% to 0.1%, which is when the original 10% tariff on the $200 bn of imports from China were actually implemented and began to take effect. 

"Given trade headwinds and no support from ECB policy (inflation expectations are on their lows) it’s hard to see anything other than a short squeeze supporting the EUR. Thus the 1.1260/1300 area will prove sticky resistance for EUR/USD," says Chris Turner, head of FX strategy at ING Group.

The next round of tariffs will be more than double the 10% original rate and shall apply to an even larger portion of the China's annual exports to the U.S., which means the economic fallout in Europe could also be larger this time around. 

However, increased friction between the U.S. and China is not the only headwind that Europe and the Euro will need to contend with over the coming months, as the UK's orderly exit from the EU remains far from guaranteed and President Donald Trump has until this Friday to determine if he will impose tariffs on imports of cars from Europe.

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