EUR/USD not that far if EU leaders cannot agree on coronabonds

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  • The coronavirus crisis is taking a human and economic toll on Europe.
  • Germany is trying to fend off demands for mutual debt, which threatens the integrity.
  • The worsening political situation may weigh on EUR/USD, potentially sending it to parity.

Over 50% of the global death toll from coronavirus is concentrated in Italy, Spain, and France – over 24,000 out of 42,000 at the time of writing. These countries are also bearing the brunt of the economic pain brought by the lockdowns.

It is, therefore, no surprise that these three countries have led the demand for the eurozone to issue common bonds – dubbed “coronabonds” to share the burden. Around a dozen states have joined these three, while Germany and the Netherlands are leading the camp opposing Eurobonds – as they did at the height of the debt crisis.

Monetary action

Back in 2012, the then President of the European Central Bank Mario Draghi said he would “do whatever it takes” – and that was enough to turn the tables. The ECB has been the “only game in town in the past decade, but is it enough against the coronavirus crisis?

Christine Lagarde, the current head of the ECB, is also doing everything possible after an initial gaffe. The bank has pledged an additional €750 billion in its Pandemic Emergency Purchase Programme (PEPP), reaching a total of €1 trillion this year. Moreover, in this PEPP, the ECB loosened its self-imposed rules in three ways.

First, the bank dropped its issuer limit, and it can now buy more than a third of a country’s debt, contrary to previous programs. Second, the Frankfurt-based is now buying Greek bonds that were uneligible under its prior rules and will also pick up short-term debt with maturities of less than a year – which some may see as monetary financing.

The third – and perhaps most significant change – is that the ECB abandoned its capital key limits. It can use the PEPP to buy more Italian and Spanish bonds than their share in the bank – which reflects the size of their economies.

Why ECB action is not enough

Will this third step be enough to help the struggling southern European nations? Both countries have shut down non-essential work in their latest rounds of restrictions and need help more than others.

However, the €750 billion additional pledge and its flexibility may be far from sufficient. Even after the curve of infections is flattened, life is unlikely to get back to normal instantly. The exit strategy will likely consist of gradual lifting of restrictions every few weeks, with potential setbacks.

Moreover, the virus-stricken economies need more than cheap loans – they require investment to rise up from mass unemployment that the crisis entails.

Germany has finally opened its purse strings and allowed for new debt, breaking away from its constitutional debt-brake. However, according to The Economist, the amount of new spending amounts to only 2% of the euro area’s Gross Domestic Product. Citibank economists estimate that around 5% of GDP in current expenditure is needed.

Political implications and EUR/USD

Coronabonds – or common Eurobonds – are needed to show that every country has the backing of others, and not only cheap loans from the unelected central bank. Mutual guarantees – which may also mean a transfer of funds between countries – would show investors the unity of the old continent to confront the crisis. The private sector would jump in if it knows that there is a joint effort.

If Germany and other countries continue opposing the much-needed bonds, the fissures along the continent could widen. The political division would hurt confidence and weigh on private-sector investment.

The ECB has its own north-south divisions – and countries would not be able to lean on favors from the central bank for too long without political will.

So far, the political disagreements have surfaced, but have only resulted in inconclusive summits – maintaining the status quo. However, frustration is growing in Spain and Italy, with France also growing impatient. Leaders of these countries could become more vocal, putting additional pressure on Berlin. Escalating tensions would then weigh on the euro.

If the situation worsens, investors may fear a re-run of the 2012 crisis – which became existential for the euro. In this scenario – which seems far, but events are moving fast – markets would flee from the euro, potentially pushing EUR/USD towards parity. The first target for the currency pair would be the 2020 low of 1.0640, followed by 2017 trough of 1.0340.

One sign of a growing divide could be that leaders of several countries boycott EU summits – whether they are virtual or face-to-face. It is critical to remember that centrist governments in all countries face fierce opposition from populists, who are criticizing Europe’s response.

Conclusion

Coronabonds are not just a new buzzword but are an essential tool to mitigate the economic fallout of coronavirus in the old continent. Moreover, the lack of mutual debt is a political timebomb that may explode and bring the euro down. The mere risk may push EUR/USD toward parity.

More: Coronavirus market turmoil explained: Dollar, stocks, gold, oil, and more

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About Author

Yohay Elam – Founder, Writer and Editor I have been into forex trading for over 5 years, and I share the experience that I have and the knowledge that I’ve accumulated. After taking a short course about forex. Like many forex traders, I’ve earned the significant share of my knowledge the hard way. Macroeconomics, the impact of news on the ever-moving currency markets and trading psychology have always fascinated me. Before founding Forex Crunch, I’ve worked as a programmer in various hi-tech companies. I have a B. Sc. in Computer Science from Ben Gurion University. Given this background, forex software has a relatively bigger share in the posts.

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