Euro outlook overshadowed! The European Central Bank is caught between the Federal Reserve and a raging political storm

Zhitong Finance APP noticed that the political environment facing the Euro suddenly deteriorated, causing investors to typically sell the Euro. However, the increasingly unpredictable global interest rate outlook has cast a shadow over the Euro's prospects.

So far, the result is that the Euro has slightly declined in the past week, but remains consistent with the six-month and one-year average levels against the US Dollar. Due to weaker-than-expected US inflation reports in May, leading to a decline in US Treasury yields, and the impact of far-right parties winning in the EU elections, the Euro is in trouble, prompting traders to bet against the Euro using currencies other than the US Dollar.

Euro to Dollar Trend

Last week, after French President Macron announced early elections, there were new changes in the voting results in the EU Parliament. The prospect of a far-right Prime Minister prompted investors to sell French assets. The sudden possibility of Frexit became a concern that could not be ignored, causing financial markets to avoid political turmoil. The ruling coalition in Germany also suffered a similar defeat, with the performance of the opposition far-right party being slightly better. The only ruling party that clearly won was the right-wing Italian Brothers of Italy led by Prime Minister Meloni.

Forex strategist Audrey Childe-Freeman stated that the bearish outlook for the Euro against the Swiss Franc or the British Pound is more evident. Even though the official rate of 1.5% is much lower than other central banks' rates, the safe-haven status of the Swiss Franc is undeniable. The European Central Bank lowered the deposit rate to 3.5% earlier this month, further widening the gap with the Bank of England's rate of 5.25%.

However, what may have a more profound impact on the currency market dynamics is the exchange of positions between the UK and France on political stability issues. The UK's Labour Party is expected to win a majority on July 4th, with investors believing that since the Brexit referendum in 2016, the UK government has experienced eight years of turmoil, while the Labour Party is expected to usher in five years or more of stable governance. Starting next month, if France has to endure a dramatic role reversal with a Prime Minister from a different party and different fiscal ideology than Macron, it will be a dramatic shift. French Finance Minister Bruno Le Maire hinted last Friday that he may not stay on after the elections.

Euro to Pound and Franc Trend

Until the final round of voting results on July 7th, the yield spread of French government bonds over German government bonds (which surged to a record 7-year high last week) may remain at high levels. France and Italy may soon be subject to the EU Commission's so-called "Excess Deficit Procedure," which would be of no help Recently, the deterioration of their respective annual budget deficits, coupled with the increase in total debt, means that the European Union may have to take a serious stance.

The yield spread of French and Italian government bonds over German government bonds continues to rise.

France's credit rating has been downgraded twice to AA-, with Fitch Ratings first downgrading it on October 20 last year, and Standard & Poor's Global Ratings downgrading it again on May 31. Moody's Investors Service currently upgraded France's rating by one notch to Aa2, with a stable outlook. The company stated last week, "Given that the next government will inherit a severe fiscal situation, potential political instability is a credit risk." Further downgrades (at least in terms of rating outlook) seem inevitable.

A report released by the European Central Bank emphasizes that the euro's global reserve currency status is also under threat. Over the past year, foreign central banks have reduced their holdings of euros by over 100 billion euros, reducing the euro's share globally to the lowest level in three years at 20%. Both Japan and Switzerland have liquidated foreign exchange reserves to defend their own currencies.

Russia once held nearly half of its foreign exchange reserves in euros as a diversification strategy away from the US dollar. This approach is now being questioned as Euroclear, Brussels' custody agency, refuses to release any securities from Russia's national accounts. G7 leaders agreed on Thursday to transfer $500 billion in profits from Russian-held bonds to Ukraine.

Following the interest rate cut on June 6, European Central Bank President Lagarde said at a press conference, "Wish you a pleasant summer," which was interpreted as indicating that a second consecutive rate cut at the next meeting on July 18 is unlikely. In addition, the results of the quarterly policy review on September 12 are deliberately left pending.

The economy that the European Central Bank needs to support is much weaker, but it will be difficult for it to continue acting alone. The timing and impact of when the Federal Reserve will lower borrowing costs will have far-reaching consequences. The situation will be determined by US Treasury yields and the trend of the US dollar.

In May, core consumer prices in the United States rose by only 0.16% - the lowest level since August 2021 - and producer prices saw the largest decline in seven months, reigniting market expectations for how aggressively the Federal Reserve will ease monetary policy this year, supporting the value of the euro against the dollar.

However, it has proven extremely difficult to judge the direction and momentum of the Federal Reserve in the current economic environment.

Lagarde has strongly refuted accusations that the European Central Bank actually relies on the Federal Reserve; but her claims of data dependency mask a fact: policy-making is influenced not only by Eurozone data but also by US data and the Federal Reserve's response. Speculation on the political or economic prospects of the euro is best kept as far away from the influence of the dollar as possible - otherwise, the risk of severe damage is high