The EUR/AUD currency pair, which expresses the value of the euro in terms of the Australian dollar, has surprisingly spiked recently, on the back of risks pertaining to the coronavirus known as SARS-CoV-2 (a virus which causes the disease now referred to as COVID-19 in humans).
The daily candlestick chart below illustrates the recent spike, which has seen EUR/AUD prices escape their medium-term trading range.
(Chart created by the author using TradingView. The same applies to all subsequent candlestick charts presented hereafter.)
The chart above highlights the levels of 1.5920 and 1.6610, which I drew attention to in my previous article covering EUR/AUD; an article in which I indicated the potential for short-term upside, but long-term downside.
This spike in the euro has been witnessed in almost all EUR FX crosses, following a period of protracted downside into 2020 (see daily candlestick chart below for EUR/USD).
An exception to the euro's recent ascent applies to EUR/JPY, a pair which has in fact fallen, consistent with this author's bearish view of the euro versus the Japanese yen. This is telling, as in spite of recent euro strength against currencies like as the U.S. dollar (or USD) and the Australian dollar (or AUD), the Japanese yen (or JPY) has strengthened even more, owing to its safe-haven status.
Yet while JPY has strengthened practically across the board, as you would expect during a risk-off event, the euro's similar behavior is strange given that it is not viewed conventionally as a safe-haven currency. On the contrary, it has historically been viewed as a fairly risky currency; while it is the currency of the European Union, the EU is not considered as a politically stable region. The integration of many countries within the EU framework may have consolidated monetary policy, and eliminated currency volatility within the EU, but risks still remain and have instead been transmuted into political instability and bond markets (this can be viewed, for example, by monitoring spreads between Italian and German bond yields).
The purpose of this article is not to analyze the EU as a system. Rather, the point here is that capital does not flow to the EU for safety; it typically flows into the EU quickly when speculative positions are unwound. The European Central Bank's deposit facility rate of negative -0.50% is even lower than the comparable Japanese rate of negative -0.10%. While the Japanese yen is cheap to borrow, the euro is even cheaper; it is therefore attractive to use as a funding currency for acquisitions of risk assets abroad. A build-up of these leveraged positions can cause short-term spikes in the demand for euros.
This is an important reason why the euro has spiked as U.S. equities have fallen (see below; the blue line is EUR/USD inverted, while the daily candlesticks illustrate S&P 500 futures).
U.S. equities have conceded to the risks associated with the coronavirus, the virus whose social effects are likely to continue to support supply chain disruptions globally. As covered in a recent article of mine, Australia is one of the most exposed countries to the coronavirus via exports. As markets price in more risk, carry-trade positioning (including short-EUR/USD positioning) tends to unwind. This has already led to sharp upside in EUR/AUD.
These leveraged positions tend to become shaky initially due to changing market perceptions (i.e., psychological effects seed the initial moves). These initial moves, if they persist outside the bounds of normality, then serve as catalysts for larger moves (these latter moves being less psychological, and more mechanical, as traders reduce their exposures). Margin calls, which can require leveraged traders to unwind their positions, are a simple example of how sharp market moves can occur for purely mechanical reasons.
It is indeed the case that AUD is poorly positioned for the virus's effects; however, the world is more connected today than ever before. All countries will be affected. China's confirmed case count of the coronavirus is now slowing, while case counts are picking up in Europe (principally Italy). (For an up-to-date case count, see BNO News, whose record is updated regularly.)
China was able to act aggressively to contain the spread domestically, whereas more democratic countries like Italy are unlikely going to be able to take similarly drastic measures. We may begin to see a shift in sentiment here, where markets become more pessimistic on EUR, and less pessimistic on currencies like AUD and NZD (i.e. on Australia and New Zealand that have significant direct export exposures to affected Asian countries).
In other words, China (and surrounding countries) may well be able to return their economies to normality sooner than markets expect, while other countries like Italy may require much more time to contain (or slow) the spread of the virus. This could put significant pressure on pairs such as EUR/AUD, in spite of the recent upside (which was probably largely mechanical in nature).
It is also worth noting, once again, that the interest rate spread remains negative for EUR/AUD. The short-term ECB rate of negative -0.50% compares to the Reserve Bank of Australia's rate of +0.75%, indicating a spread of negative -1.25%. While the RBA could cut rates to support the economy (and its next meeting will be held on March 3, 2020), even a cut of 25 basis points would not eliminate the negative interest rate differential implied for EUR/AUD.
The bond market also appears safely negative (see below), with the one-year spread between the yields of German bunds and Australian bonds being negative -1.46%.
Notice that the yield has not moved nearly as much as EUR/AUD spot prices and has in fact dropped rather than rising. It is likely that EUR/AUD prices fall in the near term, in line with the bond market's assessment. The recent upside in the euro is, in this author's view, overdone. The pair will likely soon return to its recent trading range, below the 1.66 handle. EUR/AUD therefore presents an interesting short opportunity in the near term.
