Euro Battered as Ukraine War Intensifies with Nuclear Power Station Coming Under Attack

Above: Rafael Mariano Grossi, IAEA Director General, shows the international press and media during his press briefing as he points on a map on the situation at the Zaporizhzhia Nuclear Power Plant in Ukraine. IAEA Vienna, Austria. 4 March 2022.

The Euro to Dollar exchange rate slumped a full percent on Friday and analysts say it could go notably lower amidst a significant deterioration in the Ukraine conflict.

Stocks and the Euro were dumped while the Dollar and commodities were bought in the wake of reports of a fire at Europe's largest nuclear power station in the early hours of Friday morning.

"Global risk assets and the EUR continued to slide as new events unfolded in Ukraine," says Stephen Gallo, Head of European FX Strategy at BMO Capital. "The nuclear aspect of the latest events in Ukraine are likely stoking fears of mass civilian casualties, which would put more pressure on Western governments to suspend imports of Russian fossil fuels."

Ukraine said the blaze was started during a Russian offensive to take the key piece of infrastructure and served as a reminder of the incredibly serious nature of the conflict.

Analysts say further losses in the Eurozone's single currency are likely as long as Russian President Vladimir Putin continues on a course of destruction.

U.S. Secretary of State Anthony Blinken warned that the threat of escalation into a wider conflict was now very real.

"Ours is a defensive alliance. We seek no conflict. But if conflict comes to us we are ready for it and we will defend every inch of NATO territory," Blinken told reporters.

The Euro-Dollar exchange rate dipped below the psychologically significant 1.10 level as a result of news of the fire at the Zaporizhzhia power plant.

"Amid the ongoing war in Ukraine, the US dollar has generally strengthened; the DXY index, for example, has reached its highest level since June 2020," says Jonathan Petersen, an analyst at Capital Economics.

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The Eurozone economy and broader European Union are set to suffer a significant hit to growth and surge in inflation owing to its geographical closeness to the conflict theatre, as well as its deeply integrated energy links.

"The rapid and broad-based rise in commodity prices has caused substantial shifts in countries’ terms of trade. In addition to closer economic links with Russia, most European countries are net commodity importers, so some of the weakness in their currencies probably reflects deteriorating terms of trade," says Petersen.

The deterioration in the Eurozone's economic outlook will likely inject a dose of caution into upcoming European Central Bank (ECB) policy decisions, with economists saying the Governing Council will almost certainly delay plans to 'normalise' policy.

"Because the potential impact of the war on real economic growth in the latter is more significant in Europe, we think the ECB may have to delay or slow the pace of monetary policy tightening," says Petersen.

Analysis from ING Bank N.V. finds the war in Ukraine would dampen the pace of the Eurozone's recovery and push inflation to around 4% for the year.

As a result ING's economists say the European Central Bank will have more trouble navigating through the storm, though they still expect an end to quantitative easing in the third quarter and a first rate hike towards the end of the year.

"It is hard to see the ECB wanting to start normalising monetary policy at such a moment of high uncertainty," says ING's Global Head of Macro, Carsten Brzeski.

Above: "EUR/USD & Euribor-Eurodollar Dec-22 Futures Contract Implied Yield Spread" - Capital Economics.

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"But in the US, policy tightening looks set to go ahead as planned; indeed, Fed Chair Powell indicated in his congressional testimony yesterday that the central bank would “proceed cautiously” in tightening policy this year. As a result, the gap for short-term rate expectations between the US and euro-zone has shifted further in favour of the dollar over the past few weeks," says Petersen.

These developments pose further downside risks to the Euro.

"War in Europe has understandably taken its toll on currencies in the region and the implementation of Russian sanctions now questions the rouble’s deliverability. Pressure is building for a sizeable break in EUR/USD below 1.10 this spring," says Brzeski.

Capital Economics tell their clients that unless the war ends quickly further downside in European currencies is likely to persist.

"We think the downside risks to European currencies have increased; for example, the euro could weaken well below our current forecast of 1.10 against the dollar," says Petersen.

Higher inflation and slowing growth risks creating a stagflationary environment which is less consistent with 'hawkish' central bank hiking than would be the case in an environment where price rises are stoked by a strengthening economy and rising wages.

"In view of the risks to gas and oil supply to Germany, the EUR could find itself stifled by a new wave of growth risks and potentially by increased concerns about stagflation," says Jane Foley, Senior FX Strategist at Rabobank.