Dollar – Euro exchange rate: downward risks on the euro remain sizeable

Our view – expressed in March – that the euro would gain ground against the US dollar was clearly wrong. On the back of a violent re-intensification of the euro area sovereign and banking crisis, the euro fell heavily against the greenback recently: -5.6% since the beginning of May to USD1.25 per EUR currently.

What can we expect in the future? The highly dominating factor is likely to remain the euro area debt crisis. Unfortunately, largely unpredictable political decisions will be key for the future of Greece within the euro zone, the future of the single currency project itself, and obviously for the euro’s behaviour in the forex markets. Nevertheless, for the sake of short-term investment decisions, we can try to estimate the probabilities of different possible scenarios regarding the resolution or non-resolution of the ongoing crisis. 

Scenario I:Greece stays in the euro zone
We believe there is a 55% chance that Greece will stay in the euro zone, at least over the coming 3-6 months. In that case, the oversold euro will probably register a bounce back. However, the rebound is likely to remain relatively limited, for at least three reasons: 1) even if over the highly risky coming few weeks political decisions are taken to “save” Greece, doubts will remain over the medium run; 2) a credible plan for Greece to stay in the euro zone is highly likely to require, one way or the other, further expansion in the ECB’s balance sheet, not a very supportive development for the euro in itself; 3) even if Greece stays in the euro zone, the euro area economy is likely to remain quite weak, at least in comparison with the US. As a result, any rebound in the euro against the dollar may well prove limited, and possibly short-lived.


Scenario II: Greece leaves the euro zone
In this second scenario, Greece leaves the euro zone in one of two ways: 1) in an orderly fashion, with widespread contagion avoided, or 2) in a disorderly fashion, with contagion and other currencies exiting the European currency, or a complete euro breakup. We give the first outcome a 30% probability, and the second a 15% probability. In both cases, we believe the euro will fall further against the dollar. In the first case, the euro will probably fall substantially to levels around USD1.15-1.20 per EUR. In the second case, the euro should collapse and parity may well be reached, at least temporarily.

Risk/reward management
To summarise, and still with a 3-month horizon in mind, we see a high probability of a moderate euro rebound and a lower – but still quite high – probability of a substantial further fall of the euro against the dollar.

In the current very uncertain environment, priority should be given to risk management. Even at the present exchange rate, the downward risks on the euro remain considerable in our view.

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