With the recent announcement of Germany's economy having negative Gross Domestic Product (GDP) growth for two consecutive quarters, it's fair to say that Germany is in a technical recession and is likely taking Europe down with it. While some are optimistic thanks to the recent rally in tech stocks, it certainly isn't a good sign when the largest European economy shows signs of economic weakness. In this article, we’ll explore everything you need to know about the euro, what the data suggests about the eurozone outlook and how this might impact the euro on the forex market.
What Is the Euro?
The euro is the official currency of 20 of the 27 European Union (EU) member states and is believed to be the world’s second reserve currency after the US dollar. After introducing the euro in 1999, most EU countries mobilised to phase out their domestic currencies by 2002.
What Is the Link Between the Euro & the German Economy?
Before diving into our euro to Dollar forecast, it’s vital to understand how the German economy impacts the eurozone and the outlook for the euro. Since Germany abandoned the Deutsche Mark and adopted the euro in 1999, it has significantly influenced the currency's overall performance. Despite the eurozone consisting of more than 20 member states, Germany’s economy alone accounts for almost 30% of its economic output. The country's strong economic performance since its switch to the euro has meant that Germany has become a key player in maintaining the strength of the eurozone as a whole. For example, during the European debt crisis, countries like Greece and Portugal struggled with debt and relied upon the robust strength of Germany's economic policies to tide them through the multi-year debt crisis.
Furthermore, as a significant exporter within Europe, Germany benefits from having access to a stable and homogenous currency that reduces the need for currency swaps and exchanges. This unified currency helps German companies remain competitive in international markets, which then further bolsters their domestic economy.
The EUR & the DAX
For the uninformed, the DAX is a stock market index that measures the performance of the 30 largest and most liquid German companies. According to the chart above, the euro positively correlates to the DAX. While the swings of the DAX are more volatile, we can observe that the Euro Currency Index largely follows the movement of the DAX over time. A multitude of factors can explain this.
The biggest reason we’d like to highlight is that Germany is the largest economy in Europe and has a GDP larger than both Italy and Spain combined. This means that their economic performance has a huge influence on the region and the euro's exchange rate. This is because the euro plays a significant role in facilitating trade, investment and economic activities within Germany and between Germany and other Eurozone countries. This implies an increase in demand for euros whenever Germany’s economy flourishes.
Why Has Germany Gone Into Recession?
At its core, Germany’s economy has fallen into a recession because of the rampant inflation caused by the energy price shocks of 2022. As a result of the Russia-Ukraine conflict, oil and gas prices spiked. The German economy had to suffer with this significant rise in oil prices, which put immense pressure on its production costs. This caused the country’s exports to take a hit and domestic consumption to be exceptionally weak as general prices rose. These factors combined undermined national growth levels and led to a fall in Germany’s GDP.
Euro Forecast: Understanding How Germany's Recession Might Impact the Euro
As the demand for euros drops due to a slowdown in German economic activity, this has in turn caused its value against other major currencies such as the US dollar and Chinese yuan to drop. This highlights how the euro may become increasingly vulnerable to future price shocks, such as the one in 2022. The worst-case scenario is that a similar event could occur again and cause an even bigger shock to the euro than before. Such an event would be highly detrimental to Germany and its neighbours and the European Central Bank, which rely heavily on the euro as an international reserve currency.
What Factors Affect the Euro?
Besides Germany’s recession, here are some other factors that might affect the strength of the euro.
The World Economy
In a strong economy, investors and traders tend to hold less cash and would rather invest their euros in assets that offer higher rates of return. This would cause the euro to weaken as supply for it increases. Conversely, in a weak economy, the euro would likely appreciate as demand for it increases because of its status as a safe haven reserve currency.
Germany’s Balance of Trade
From exporting cars to motor parts, Germany has leveraged upon its strength of German engineering and lived up to its net exporter reputation for the past few decades. However, this strong trade surplus seems to be at stake as Germany’s trade surplus reaches its lowest in two decades. This has put pressure on the euro as there’s lesser demand for euro to facilitate trade with Germany.
Economic Strength of Europe
The strength of a currency largely reflects the state of its economy. With Germany experiencing slowing GDP growth and high inflation, we’ll likely see these factors contribute to the euro’s weakness as investors and traders seek alternatives with higher returns.
Will the Euro Continue to Weaken?
The future of the euro remains uncertain as economic conditions in Europe continue to be volatile. With inflation proving incredibly sticky and continued unrest thanks to the Russia-Ukraine conflict, there is a possibility that the euro could further weaken against other major currencies as Germany and other European countries continue to suffer from last year’s energy price shock.
On the other hand, if Europe can and any potential crisis can be avoided, then it is possible that the euro could remain relatively strong. In either case, it appears that the outlook for the euro remains uncertain in the near future.
Euro Technical Analysis
On the Technical Analysis side of things, EUR/USD looks to be on a downward trend thanks to the declining value of the euro. After peaking at the 1.109 range, the EUR/USD pair has been falling for the past few weeks, having made lower highs and lower lows as it trends downwards within the descending channel.
As EUR/USD continues to trend downwards in the near term, we will likely see a bounce off the strong 1.053 support line. There will probably need to be a major macroeconomic factor that’s dire enough to catalyse a downward movement past the support line shown above.
Short-Term & Long-Term Forecast for Euro
In the short run, we’ll likely see the euro continue to weaken. This is likely because of the impending news that other European economies like Italy and France will also face slowing growth as they face similar inflation pains thanks to energy-related price shocks. As the recessionary environment chips away at the bullish euro sentiment, demand for the euro will fall as investors and traders flee and seek alternative currencies like the US dollar which offers higher rates of return.
In the long run, as the European Central Bank (ECB) continues to hike interest rates towards its targeted 4%, we might see demand increase for the euro to take advantage of the increased yield. Investors and traders will want to keep a close eye on the fiscal policies implemented by the German government and the ECB as they aggressively attempt to keep inflation under control.
The Bottom Line
Germany's recession has kickstarted inflationary pressures in Europe, raising concerns about the overall state of the eurozone's economy. While projections indicate a gradual recovery over time, uncertainties and challenges persist in the form of global conflicts and stubborn inflation. In order for the euro to overcome these bearish macroeconomic conditions, policymakers must adopt prudent measures so the likelihood of a eurozone economic crash can be averted
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