EUR/USD in Focus as Economists Warn Eurozone Faces Sizeable Dent from "Trade War" with US

-EU-US trade war could cost 0.7% of GDP say Bank of America.

-EURUSD fall to parity necessary to offset dent to the economy.

-But EURUSD forecast for year-end remains at 1.20 for now. 

© Lisa L, Adobe Stock

The Eurozone economy has a lot to lose in any so called trade war with the United States, according to new research from analysts at Bank of America Merril Lynch, who argue that the Euro rate would have to fall to parity against the Dollar in order to fully offset the effect of new tariffs they expect the White House to announce against the European Union. 

Analysts from Bank of America warned in an economics briefing Monday the White House will likely slap a 25% tariff on cars imported into the United States from the EU, placing a significant Eurozone industry under threat, and that it could ultimately even go as far as imposing a 10% levy on all goods imported into the US from Europe. 

President Donald Trump said in May that the US is launching a section 232 investigation under the Trade Expansion Act 1962 into whether the automotive industry landscape presents a threat to US national security. This is the same pretext that was used for earlier tariffs on steel and aluminium imports but Tuesday the administration hinted the auto investigation may be moving much quicker than its predecessor.

....We are finishing our study of Tariffs on cars from the E.U. in that they have long taken advantage of the U.S. in the form of Trade Barriers and Tariffs. In the end it will all even out - and it won’t take very long!

— Donald J. Trump (@realDonaldTrump) 26 June 2018

"We assume trade war escalation with a 25% tariff on cars and 10% higher tariffs on all other products," says Evelyn Herrmann, a Europe economist at Bank of America Merril Lynch. "It would take a chunky 17.5% USD appreciation to offset this effect - EURUSD would need to go to parity to offset the tariff impact on growth."

This comes after the European Union imposed tariffs on imports of Harley Davidson motorcycles into the EU in retaliation for earlier US levies against European steel and aluminium, prompting Harley Davidson to shift some of its international production into Europe and drawing an angry response from President Donald Trump. 

Surprised that Harley-Davidson, of all companies, would be the first to wave the White Flag. I fought hard for them and ultimately they will not pay tariffs selling into the E.U., which has hurt us badly on trade, down $151 Billion. Taxes just a Harley excuse - be patient! #MAGA

— Donald J. Trump (@realDonaldTrump) 25 June 2018

The US is currently locked in a tit-for-tat tariff fight with China, the world's second largest economy, over alleged unfair trading practices, which has stoked fears of a so called trade war. The White House also signalled repeatedly that it will soon lock horns with the EU, with Trump focusing on the bilateral trade deficit and imbalance between tariffs charged in both directions. 

"We find that 0.4% of total Euro area GDP is linked to US car demand, again with relatively large variations across member states. Although non-negligible, Euro area exposure to the US is lower than that of Canada or Mexico, and that of South Korea or Japan," Herrmann adds. 

The European automotive industry generates more than half a trillion Euros in revenue annually and is responsible for hundreds of thousands of jobs. The US is also one of Europe's two largest markets, with China being the other.

Bank of America estimates that a 25% US tariff on cars imported from Europe will hit the bloc's GDP by almost 0.4%, although the economic damage rises further if the US goes ahead with a further 10% tariff on all goods imported from Europe, not just cars.

"Escalation of the trade war could go much further than the car industry. In total, the Euro area has exposure to US end demand of c 2.5% of total Euro area GDP (Chart 3) - c 0.4ppt of those are cars. Assuming 25% of tariffs on cars and 10% on all other imports, we could see c 0.7% of Euro area GDP at risk," Hermann says.

Hermann and the BAML team use "value chain" analysis to quantify the likely economic impact of the tariffs because it is better suited to the current task than traditional import and export data, given the complexity of supply chains in the automotive industry.

"Why do we prefer to look at value-added, ie the production side of GDP, rather than simple export value shares? Typically, exports contain a lot of imports (c 30%). What does this mean? When Germany exports a car worth EUR10,000 to the US, this car will contain many intermediate goods imported from Eastern Europe, for instance. Value-added in Germany, therefore, is typically only a fraction of that," Hermann writes, in a note to clients. 

Photographic lenses and cameras are another good example of why value chain analysis may be a better tool for quantifying the economic impact of tariffs. Photo camera lenses produced in Germany may be exported to China, where they are assembled and sold on to the United States. 

Traditional import and export data would show this as simply German-Chinese trade when, as would be highlighted by value chain analysis, much of this trade is actually linked to America.

"Trade wars are a complicated undertaking for Europe, as we argued before. Retaliatory action against the US tariffs requires a consensus across EU member states. Yet, trade openness and exposure the US vary a lot across economies," Hermann notes.

For the Euro-to-Dollar rate, much depends on whether the current mood between the US and EU deteriorates further. For now, the exchange rate has already reached Bank of America's second-quarter forecast of 1.15 and the FX team are still projecting that it will recover to 1.20 before year-end. 

However, the German ZEW Economic Sentiment index fell to its lowest level since September 2012 this June, with the Zentrum fur Europaische Wirtschaftsforschung saying EU-US trade tensions and concerns over the new Italian government have dampened business confidence and dented the Eurozone economic outlook. 

This is important for the single currency because its meteoric rise in the 12 months to April was hinged largely on market hopes the European Central Bank will wind down its quantitative easing programme in 2018 and be in a position to raise interest rates some time in 2019.

Already, and assuming its ambitious growth and inflation forecasts are met during the next 12 months, the ECB has told markets it will still not contemplate raising rates before the end of summer 2019.

This sent EUR/USD tumbling by nearly 2-300 points on June 14 and if the current "trade war" escalates, it might not be long before analysts are downgrading their forecasts for Eurozone growth, inflation and the Euro-to-Dollar exchange rate. 

The Euro-to-Dollar rate was quoted 0.35% lower at 1.1658 Tuesday. It is down by 2.8% for the 2018 year to date. 

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