EUR/USD Slide Underlines EU Breakup Risk

The decision by the UK electorate to reject membership to the European Union has roiled financial markets across the globe since the votes were tallied last Thursday, adding to the risk of further defiance towards greater EU integration. While some have hailed the efforts as voters making a stand against unelected technocrats, for the EU leadership in Brussels, the move creates a new set of headaches as they attempt further political and economic consolidation. As a result of greater rejection of austerity and a stripping of national sovereignty, opposition leaders in France, Holland, Italy, and Spain have heightened calls for their own referendums on policy, leading to increased uncertainty for the future of the monetary union. While no imminent interest rate increases are set to be delivered by the US following the “Brexit” decision, the real risk for EUR/USD comes in the form of rising Euro Area breakup probabilities.

Globalism Rejected

While the UK may not be the full source of pain and misery in the Euro, it does underline voters’ dissatisfaction and frustration with the European Union and Euro Area currency bloc. One of the harshest critics has been far right National Front Leader Marine Le Pen of France. She has called for a similar exit as voters grow wary of loose border controls and the increasing grip of Brussel’s-based unelected technocrats that are making critical decisions for member countries. While German Chancellor Angela Merkel has tried to downplay the risks of a UK exit, France and Germany have used the current crisis to increase calls for greater integration and a potential European super-state that would in effect further reduce national sovereignty.  Although in theory greater political integration would lead to better economic management and centralized fiscal policies, the backlash to these ambitious plans has been growing.

Even though the Euro Area leadership is likely distraught and dismayed by the latest market momentum which has seen the Euro tumble, is does ease some pressure on the Central Bank which has engaged in extreme accommodation measures in order to spur economic activity. The ECB is currently buying sovereign and corporate bonds at a pace of nearly EUR 85 billion per month in an effort to stimulate lending and investment across the region. Furthermore, it has taken rates into negative territory in an effort to also raise consumer spending instead of saving to drive growth in the embattled region. Now that the Euro has recorded a significant decline, it should help export growth as Euro Area goods like those from export powerhouse Germany become more competitive in global markets.

However, despite the potential export gains, with the “Brexit” uncertainty weighing on the outlook, it means that a further wedge between the ECB’s interest rates and those of the Federal Reserve are likely to diverge further as time passes. Fed Funds futures are signaling no action on rates in 2016, but US prospects are significantly better considering the strengthening economic backdrop. Greater uncertainty might also hamper business investment as companies wait for the dust to settle, hurting the efforts directed towards tackling unemployment and deflation. Even though a weaker currency could help fight falling consumer prices which have been in negative territory on an annualized basis for the 3 of the last 4 readings, deflation has a tendency to be self-fulfilling. A result of deflation is that consumers and businesses will likely postpone purchases with the expectation of further price declines. Taken together, these developments will hurt economic activity and continue to weigh on EUR/USD.

Technically Speaking

Since the blowback from the referendum vote, EUR/USD has fallen significantly from slightly over 1.1400 to below 1.1000 before rebounding back above the key psychological level. After slipping below both the 50-day and 200-day moving average last week, the 200-day moving average has stood in the way of any sustained bounce in the pair, serving as resistance against a rebound. With the 50-day moving average now trending lower, it is also acting as resistance and should it cross the 200-day moving average to the downside over the coming sessions, it could be an extremely bearish sign for EUR/USD going forward, representing a “death cross” formation. Furthermore, adding to the sustained bias to the downside is the relative strength index and stochastic oscillator. Neither indicator has necessarily signaled the pair is undervalued or oversold, suggesting no potential buying opportunity and paving the way for further losses.

Bounce Temptations

Although trading any bounce in the EUR/USD pair may be tempting considering the steepness of the recent decline, from both a political and economic perspective, catching the falling knife could prove an extremely risky proposition. For one, the high levels of accommodation undertaken by the ECB combined with the increased prowess of the US economy are stoking a divergence in policy which will likely help US dollar appreciation.  Second, the UK exit has paved the way for other member states to vote on their own continued EU membership, a development that could destroy confidence in the European Monetary Union’s ability to maintain its membership base. Countries exiting could crush the resolve the ECB to fix the ongoing economic woes, thrusting the region into further chaos. As a result of the worsening visibility, the EUR/USD is poised for further losses until the dust settles.