By Saikat Chatterjee

LONDON, (Reuters) – The drop in the euro to a 5-year low has rekindled the possibility that the currency could reach parity with the dollar for first time since two decades. Investors are encouraged to take bearish bets because of fears of a recession in the euro area.

Russia’s recent decision to suspend gas supplies to Poland and Bulgaria are just two of the many blows that Russia has dealt to its currency. The currency is already under severe pressure due to twin headwinds: a rising dollar and massive COVID linked lockdowns in China. China is a significant market for bloc exports. Germany, and possibly other European countries may be the next to have gas supplies cut off.

“The embargo may tip the European economic economy into recession quicker than expected and as such we are shorting the euro, expecting it to fall to at least $1.05 in near term and possibly towards parity,” stated Kaspar Hense from Bluebay Asset Management.

Some high-frequency economic and financial indicators flashing in red as the single currency plunged to $1.0514 against USD, making April losses of 4.5%.

The data from Germany, the largest economy in the Euro zone showed that consumer sentiment was at an all-time low. In addition to cutting its growth projections for 2022, the government also cut their forecasts. The credit default swap index revealed that the cost to insure exposure to European debt with lower ratings is at its highest level in 2 years. This highlights the risks faced by companies.

Vasileios Gkionakis EMEA head for G10 FX strategy, Citi stated more downside was possible, and that “speculative position is much cleaner” than it has ever been. There is also potential to accumulate larger amounts of’shorter’ currency.

In fact, the one-month dollar/euro risk reversals (a market indicator of how much options are being offered on currencies rising or falling) moved quickly on Wednesday to indicate that there was more weakness.

From Wednesday’s previous day, the ratio between call options and puts nearly halved to minus1.8 on Wednesday. It is now the lowest point since mid-April. Puts allow holders to trade while call options grant the right to purchase an asset.

GRAPHIC: Euro risk reversals https://fingfx.thomsonreuters.com/gfx/mkt/gkplgkbwnvb/euro%20risk%20reversals.JPG

THE LESSER HAWK

Since peaking at $1.6 2008, the euro has fallen steadily. There is little to no benefit from any expectation that the European Central Bank will raise its interest rates by 80 basis points this year.

This is because the markets have been prepared for a much more aggressive U.S. Federal Reserve tightening, and money markets bet that U.S. rates would rise by 1% at the two upcoming meetings.

Currently, ECB rates are at -0.50%. They won’t go up to U.S. level this year.

The euro zone is about getting the deposit rate to a positive area and possibly back into slightly positive territory before year’s end. This means the European currency is depreciating,” stated Craig Inches from Royal London Asset Management.

Inches highlighted that euro’s decline against currencies of trading partners is worrying for bond-investors as it may exacerbate the bloc’s 7.4% inflation.

He said that a worsening inflation outlook caused by currency weakness makes it necessary to evaluate the value of bond yields. “Are we being compensated for the inherent term prepayment and future inflation risks with longer-dated bonds?” he added, adding that German 10-year German bonds make little sense when yields are below 1%.

GRAPHIC: Euro trade-weighted https://fingfx.thomsonreuters.com/gfx/mkt/zgvomlarkvd/eurotradeweighted.JPG

A HURDLE TO PARITY

It won’t be easy to move towards euro-dollar parity, as currency traders will face stiff technical obstacles.

Two traders have indicated that the Euro’s downside is being protected by substantial option contracts. These options contract are around $1.0340 at the beginning of 2017, and $1.02 at December 2002.

Swift actions could also be a reason for intervention from the ECB. This was most recently seen in 2011 and 2000.

This latest decline may partly be due to a position clean-out. Weekly data from Commodity Futures Trading Commission revealed that hedge funds were generally neutral about the euro. Short positions are well below highs recorded in early 2020. .

Few banks can forecast the euro-dollar parity being hit. HSBC, for example, says that 1.0341 levels of early 2017 may be possible “if macro- and political challenges do not abate”.

Rabobank said it would reconsider its $1.10 euro forecast, noting the “stronger-for-longer” dollar, but expects “euro-dollar parity will be side-stepped” if energy supply disruptions are averted and ECB policy tightening stays on course.

GRAPHIC: Euro slides to five-year lows https://fingfx.thomsonreuters.com/gfx/mkt/zjvqkmyxbvx/euro2704.PNG