Euro-Dollar Upside Seen at Societe Generale but Not if Brexit Hits Sterling Again

© Mohamed Yahya, Reproduced under CC licensing

- EUR upside significant but losses likely in 'no deal' Brexit scenario.

- As GBPUSD and EURUSD correlation will drag EUR under water.

- Euro's correlation with Chinese Yuan also key threat to the outlook.

The Euro-to-Dollar rate has scope to rise significantly before the year is out but such gains would be unlikely if the Brexit process was to drive another steep fall in the value of Pound Sterling, according to Societe Generale.

Both Euro and Pound-to-Dollar exchange rates have long shared a strong positive correlation that is more than just the result of each exchange rate occasionally being driven by the Dollar side.

It's this correlation that would likely drag the Euro underwater in a possible Brexit storm, which could well break in October 2019 if the UK parliament refuses again to back Prime Minister Theresa May's Brexit proposal on the fourth asking in June.

PM May intends to put her EU withdrawal agreement to a fourth and final vote in parliament on June 03, although this last roll of the dice is still widely expected to result in another rejection by MPs.

The Prime Minister sought to tempt MPs into backing her EU withdrawal agreement with a series of new pledges Tuesday but it remains far from certain that they will be enough to bring sufficient numbers on board.

Another rejection could mean MPs find themselves faced with a choice between abandoning Brexit or pursuing a 'no deal' exit that sees the UK default to doing business with the EU on World Trade Organization (WTO) terms.

"Given positions and valuation, it's easier to see EUR/USD at 1.20 than 1.05 in 6-12 months' time but there are two clear downside risks in the short-term (1-3-months): a weaker yuan and a weaker pound," says Kit Juckes, chief FX strategist at Societe Generale. "The correlation between GBP/USD and EUR/USD speaks to the importance of the UK to the Eurozone as well as the importance of the Eurozone to the UK."

Above: Pound-to-Dollar rate at daily intervals alongside Euro-to-Dollar rate (orange).

Both the Euro and Eurozone economies have underperformed this far in 2019 although so too have most other G10 currencies. A strong Dollar and the impact of the U.S.-China trade war on Europe's economy are responsible for that. 

Analysts have long favoured an end of the Dollar's post-2017 reign over G10 rivals in 2019 and a concurrent recovery of the Euro-to-Dollar rate. But many also say a possible no-deal EU exit by the UK would send the Pound-Dollar rate as low as 1.15, from 1.27 Tuesday.

"Sterling's main support is that in trade-weighted terms it is close to extreme levels, but that may not count for much as we enter another summer of political upheaval, again. If sterling takes another significant knock, that too will hurt the euro," Juckes warns.

The Pound may not need to wait until October before losses mount again either because Prime Minister Theresa May is under increasing pressure to resign from office and make way for a Brexit-supporting replacement.

Above: GBP's rolling one-week performance vs G10. Monday, 20 May. Source: Pound Sterling Live.

This pressure comes as The Brexit Party, led by Nigel Farage, rises through the opinion polls and as expectations mount that the governing Conservative Party will suffer a drubbing in Thursday's EU parliament.

Such an outcome from the forthcoming election might simply serve to put a 'no deal' Brexit squarely on the radar of the market once again. Pound Sterling was the G10 universe's worst performing currency last week.

Those Brexit concerns might also weigh on the Euro over the summer, although Juckes' says the UK's looming departure from the EU is far from the only downside risk to the Euro, as China's currency also poses a threat.

Above: Euro-to-Dollar rate shown at daily intervals alongside USD/CNY (blue).

"It's hard to know how to gauge the probability of the Chinese authorities allowing USD/CNY to break higher, or of another sterling confidence crisis, but they are risks that can disrupt the current EUR/USD range and both would drag the euro lower," Juckes says.

The Euro shares exactly the same kind of correlation with the Chinese Yuan as it does with Pound Sterling and markets are increasingly speculating that the latter will devalued by the People's Bank of China before long.

This is after President Donald Trump's raised from 10% to 25% the tariff levied on around $200 bn of annual imports from China, prompting a retaliation in relation to $60 bn of Chinese imports from the U.S.

Trump has also set the ball rolling on a process that could see a 25% tariff imposed on China's remaining $300 bn of exports to the U.S. and rhetoric from both governments has been increasingly hostile of late.

And one way for China to offset at least some of the economic impact that those tariffs might have is through devaluing its currency, as Chinese exports would then become cheaper for U.S. and other foreign firms to buy.

"A near-term break of USD/CNY 7 may be unlikely, but it would drag EUR/USD through the year's lows and could trigger stops," Juckes warns.

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