​Euro on the verge of ugly downtrend

Goldman Sachs implied the euro could fall below 1 per dollar in a scenario in which Donald Trump imposes widespread tariffs and cuts domestic taxes if he wins the presidential election.

A 10% US tariff on all imports and a 20% levy on Chinese products, combined with tax cuts, could cause the dollar to rally sharply and the euro to drop 8% to 10%, according to the bank.

The Republican is currently neck and neck with Vice President Kamala Harris, but his radical economic policies would likely have the bigger impact on Europe, a key trading partner of the US.

In the case of a narrower trade war, in which Trump only imposes further tariffs on China, Goldman said the euro could fall by around 3%. The single currency has weakened so far in 2024.

The euro/dollar parity was last seen in 2022, the first time in 20 years, as the ECB had raised interest rates at a slower pace than the Fed. Russia's incursion into Ukraine sparked outflow from the bloc.

A rally began in the last quarter of last year, but the tailwinds behind it are vanishing. First, US core inflation has outpaced the eurozone's for months, while the benchmark interest rate is now much higher in the US.

Second, China's recovery has slowed gradually since end of the zero Covid policy, so Europe's growth outlook will be clouded by export uncertainty until fresh stimulus takes effect in the world's second largest economy.

Warning of retaliation

German Finance Minister Christian Lindner warned that if the US kicked off a trade war with the EU, there could be retaliation. The hawkish tone is not surprising given the EU's reaction in 2018.

Brussels was caught off guard by tariffs on steel and aluminium, and retaliated only on part of those tariffs. It was shocked to see Trump willing to rip up ties with Washington's most important allies.

In the first half of 2024, Germany exported more goods to the US than to China. EU has accused Beijing of aid to Putin's war effort and hence a playbook to de-risk from its former top trading partner.

If a 20% tariff were implemented by the US, the EU's GDP would fall as much as 1.3% in 2027 and 2028, Reuters reported Thursday citing a study by German economic institute IW.

Even with tariffs of just 10%, the German economy would suffer partly due to the uncertainty weighing on investment and consumption, said Juergen Matthes, head of international economic policy at IW.

German car exports would be particularly hard hit, down 32%, said ifo. The industry is already struggling as Chinese EVs have been increasingly popular among local customers over time.

Germany will this year be the only G7 country failing to grow for two consecutive years, according to the latest forecast by the IMF. Basically further deglobalisation will be the last thing the industrial nation seeks.

Debate among ECB

ECB policymakers have begun to debate whether interest rates need to be lowered enough to start stimulating the economy with the so-called neutral interest rate yet to be detected.

The IMF puts the level at 2.5%, ECB watchers polled by the bank see it at about 2.25%, ECB staff thinks it's close to 2% or just above it, and market pricing suggests it is now below 2%.

Inflation has been well below earlier predictions over the past few months, raising the risk that price growth could undershoot the 2% target, much like it did for nearly a decade before the pandemic.

This is prompting growing group of policymakers to argue that the central bank has fallen behind the curve and deeper cuts will be needed than earlier thought to prevent inflation from going too low.

The euro zone economy grew faster than expected last quarter but still showing fragility as industry remained in recession and household consumption barely grew, Eurostat data showed on Wednesday.

Without conviction of a turnaround, labour market could quickly soften, adding to the downward pressure on prices. The ECB will have to step up loosening assuming more tariffs in place.

And it is not certain if a Harris victory will in deed benefit the currency. While her tax hike plan may dent confidence in soft landing, we still do not rule out the risk of eurozone's underperformance.

Disclaimer: This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by EBC or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.