Euro-Dollar Placed Up for Sale as Risk of U.S.-Style Shutdown Over EU Budget Looms Large 

- EUR/USD sold at TD Securities, CIBC warns of weakness.
- As EU showdown on budget, rule of law looms over EUR.
- Vetoe of next budget risks U.S.-style shutdown in Brussels. 
- Berenberg says economic fallout limited, costs are political.
- Rabobank sees spat taking shine off EUR, limiting upside.

Image © European Central Bank

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The Euro-to-Dollar exchange rate sat out an advance among risk currencies and other assets Wednesday but could be susceptible to further underperformance as the threat of a U.S.-style Brussels shutdown over the EU budget looms large, which has led some analysts to advocate selling the single currency. 

Europe's unified unit was a clear underperformer with all of its major exchange rates quoted lower on Wednesday as the single currency merely trod water against a weakened Dollar, even as stock and commodity markets continued to draw support from recent developments in the search for a coronavirus vaccine. 

"We think markets are overestimating the timing and scalability of vaccine news. We also think markets are overlooking near-term risks that arise from surging Covid infections, slowing mobility trends and a smaller fiscal package (which could also see a delay in timing)," says Mazen Issa, a strategist at TD Securities, who advocates using  FX options to bet against the Euro. "This is an environment which we think augurs for a more defensive posture short-term (i.e. slightly favorable to the USD) and less favorable for EURUSD." 

The Euro has underperformed as a row over the terms of Brussels' next seven-year budget and coronavirus recovery funding, which are collectively worth around €1.8 trillion to the continent over a multi-year period, threatens to financially paralyse the bloc from January onward after Hungary and Poland vetoed the package in objection to terms inside it relating to  enforcement of EU rules.

East European members have been in conflict with Brussels for years after European officials attempted to use their interpretation of EU treaty terms covering the rule of law to oppose  policies and actions of the Hungarian and Polish governments. Hungary, which is said to be the greater impediment to a budget deal, accused the EU again this week of politcally motivated double standards in its interpretation and enforcement of its rule of law.  

Above: Euro-to-Dollar rate shown at hourly intervals alongside S&P 500 index futures (blue line, left axis). 

"The veto of the EU Budget by Hungary and Poland has yet to materially impact EUR sentiment. Expect the topic to be on the agenda of the EU Council tomorrow. Should the budget stall, expect weakness in EUR/USD," says Jeremy Stretch, European head of FX strategy at CIBC Capital Markets. 

Previously the ideological battle over how European countries should be ran had limited consequences for all concerned including the Euro. European officials had frequently floated idea of using financial sanctions, notably the withholding of European funds, to coerce East European into compliance with Brussels' own interpretation of its treaty rules but these attempts were always destined for failure give that each country still weilds a national vetoe over budget and spending decisions. 

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But the stakes were raised this year when at the height of the coronavirus crisis, and with economies stuck in a government-induced deep freeze, national leaders from across the bloc insterted into the terms of access for the EU recovery fund and general budget monies a condition requiring all members to adhere to Brussels' iteration of the rule of law and related enforcement actions. The condition would have seen regular EU funding worth more than 3% of GDP per year in Poland and Hungary withheld from non-compliant countries, although it as well as the seven-year EU budget agreement that it's a part of also require the unanimous approval of EU leaders. 

"Whereas Poland might drop its veto if the contentious conditionality clause is put into context by a political statement clarifying that it would only be used in very specific circumstances, Hungary objects more fundamentally," says Holger Schmieding, chief economist at Berenberg. "We believe that the EU will resolve the dispute that threatens to hold up the EU’s €1.8trn fiscal mega-deal. But it will probably not do so this Thursday already. More likely, the EU will finalise the deal in time for the 10-11 December summit. If not, the first payouts of the envisaged €390bn grants from the corona recovery fund may be delayed." 

Above: Euro-to-Dollar rate shown at daily intervals alongside S&P 500 index futures (blue line, left axis). 

Schmieding says a U.S.-style government shutdown could engulf Brussels in the New Year if national leaders are unable to resolve their differences at either Thursday's European leaders meeting or a subsequent gathering in early December. However, he also says that much like in the U.S., there's a variety of stop-gap measures that could be implemented to keep important programmes funded and Europe's bureaucratic machinery moving as the crisis is resolved.

"While this would be unfortunate, it should not make a major difference as long as key recipients such as Italy and Spain can borrow on markets at exceptionally favourable terms. That the €1.8trn package will be derailed for good seems highly unlikely," Schmieding says. 

The immediate economic impact of an vetoe could be limited if not negligible, with the bulk of the costs being of the political kind. But the dispute and its preceding war of words would still bring a spotlight back to bear on conflicts of interest between some European Union members, and the ideological estrangement of others from the bloc's centre, potentially calling into question its long-term prospects for integration, if-not survival in its current form. 

While not necessarily an imminent threat to the economic recovery, quarrels over the European budget and its related conditions do make for a fractious political environment that is hardly conducive to a strong investment case for the continent or a rising Euro-to-Dollar rate. 

"Dutch PM Rutte has stated that the Netherlands cannot accept any attempt to water down the conditions of the budget and that the compromise deal was already at the lower limit for the Dutch. Rutte even referred to a ‘nuclear’ approach which would limit the budget and Recovery Fund to just 25 EU members and omit Poland and Hungary, though clearly this would present huge legal complications," says Jane Foley, a senior FX strategist at Rabobank. "Investors may be approaching the winter with too much optimism in the price. Not only is more stimulus in store from the December ECB policy meeting which could weigh on the single currency, but EU budget concerns are again rising to the fore, Infighting within the EU could delay the roll out of the Recovery Fund at a time when there is an increased need for fiscal support in many European countries. These risks suggests that EUR/USD may not be the best medium through which to express a bearish USD view."  

Above: Euro-to-Dollar rate shown at weekly intervals alongside Dollar Index (blue line, left axis).