Analysis-Euro peers over the cliff at dollar parity as recession

By Saikat Chatterjee

LONDON (Reuters) – The euro’s drop to a five-year low is rekindling the possibility the currency will reach parity versus the dollar for the first time in two decades, as fears of a euro zone recession encourage investors to pile on the bearish bets.

Russia’s move to cut off gas supplies to Bulgaria and Poland is the latest blow for the currency, already pressured by the twin headwinds of a surging dollar and sweeping COVID-linked lockdowns in China, a major market for bloc exports. Germany and other European countries could be next in line for restrictions on gas.

“The embargo could tip the European economy into recession sooner than later and as a result we are short the euro expecting it to weaken to at least $1.05 in the near term and maybe towards parity,” said Kaspar Hense, a senior portfolio manager at Bluebay Asset Management in London.

As the single currency plumbed a low of $1.0514 against the dollar, bringing April losses to 4.5%, some high-frequency financial and economic indicators are flashing red.

Data in the euro zone’s biggest economy Germany showed consumer morale at a historic low and the government sharply cut its 2022 growth forecasts . A credit default swap index showed the cost of insuring exposure to lower-rated European debt is at its highest in two years, highlighting risks companies face.

More downside is likely, said Vasileios Gkionakis, EMEA head of G10 FX strategy at Citi, adding that “speculative positioning is much cleaner than before, suggesting scope for bigger ‘short’ accumulation.”

Indeed, one-month euro/dollar risk reversals — a option market gauge of demand for options on a currency rising or falling — moved sharply on Wednesday to imply more euro weakness.

The ratio of call options on the euro compared to puts almost halved on Wednesday from the previous day to minus 1.8, the lowest since early-April. Call options confer the right to buy an asset while puts enable holders to sell.

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

THE LESSER HAWK

The euro has moved steadily lower since peaking at $1.6 in 2008, deriving little benefit from expectations the European Central Bank may raise interest rates this year by 80 basis points.

That’s because markets are prepped for far more aggressive tightening from the U.S. Federal Reserve, with money markets betting U.S. rates will rise by 1% in the next two meetings.

ECB rates, currently at -0.50%, won’t rise to U.S. levels this year or the next.

“In the euro zone, you’re really only talking about getting that deposit rate out of negative territory and maybe back to slightly positive territory by year end. What that means is that the European currency depreciates,” said Craig Inches, head of rates at Royal London Asset…