EUR/USD analysis: EU/US natural gas spread to push euro below parity?
11:23, 16 August 2022
Since the beginning of the conflict between Russia and Ukraine, Europe has been hit by the worst energy crisis in its history, with European (Dutch Title Transfer Facility) and American (Henry Hub) natural gas price differentials widening at all-time highs and the EUR/USD currency pair dangerously close to parity levels.
According to the most recent CME Group data, US Henry Hub spot prices are currently trading at an equivalent of $57/MMbtu discount compared to Europe's Dutch TTF benchmark as of mid-August 2022.
The link between EUR/USD and Henry Hub-TTF spread has increased significantly over the course of the summer, with the rolling 90-day correlation coefficient rising to 0.79. This is basically telling us that the lower US natural gas prices trade compared to the European Dutch TFF prices, the stronger the downward pressure on the EUR/USD pair.
From a macro standpoint, the Russian gas crisis is likely to cause a more severe economic downturn in Europe than the US. Widening TTF-Henrty Hub gas price spread makes European firms less competitive than US firms in terms of input costs and also reduces real wages and household incomes in Europe more than in the U.S.
Has the market correctly priced in a recession in Europe because of the energy crisis? If so, has EUR/USD reached its bottom? Or can the gas crisis still get worse, causing the pair to break below the parity level?
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Chart to watch: EUR/USD is tied to Henry Hub-Dutch TTF natural gas spread
EUR/USD vs Henry Hub-Dutch TTF price spread and correlation analysis as of August 16, 2022 – Photo: Capital.com / Source: Tradingview EUR/USD macro outlook: Will the euro fall below 1.00 on plummeting EU economy?
The European gas crisis is wreaking havoc on the economy of the Eurozone and this effect has already been quite visible on the EUR/USD trend in 2022.
The ZEW Indicator of Economic Sentiment for Germany, a leading forward-looking indicator of the Eurozone GDP growth, fell to -55.3 in August 2022, down from -53.8 in July and below market expectations of -53.8. It is the lowest reading since October 2008, when the Great Financial Crisis began.
The persistently strong trend in inflation and the anticipated increase in heating and electricity costs during the winter continue to harm the Eurozone's economic outlook. As a result, if the US inflation rate may have reached its peak, Europe is still a long way off.
The US, a major oil and gas producer, has not experienced the same increases in energy prices as Europe, as demonstrated by the Henry Hub-TTF natural gas spread. In the absence of Russian gas, Europe has increasingly imported Liquified Natural Gas (LNG) at higher prices from the United States and other suppliers.
Consequently, the trade balance of the Euro area has deteriorated significantly, with a deficit of EUR 200.7 billion in the first half of the year, compared to a surplus of EUR 83.2 billion in the same period of the previous year. The US trade balance is also in deficit, but it has improved in recent months, aided by soaring energy exports.
Looking at the Eurozone's real wage growth dynamics - a key metric for forecasting the trend in real household incomes and consumption spending - we are currently at the lowest level on record (-6.2%). This is going to produce a negative effect on the Eurozone's consumption this winter. In contrast, the nominal wage growth in the United States is still outpacing inflation, resulting in positive real wage growth.
In summary, Europe is more directly affected by the natural gas crisis than the United States, and it is highly likely that Europe will continue to experience higher inflation and slower economic growth for an extended period of time.
EUR/USD forecasts: What to expect next?
Investors have already been quite bearish on the EUR/USD pair this year, mainly due to the widening interest rate gap between the Federal Reserve and the ECB.
Along with the economic growth and interest rate disparities between the two regions, the more severe natural gas crisis that Europe is experiencing compared to the United States is now a key macro factor affecting the EUR/USD exchange rate.
Traders should then keep a close eye on the Dutch TTF/Henry Hub spread as a key indicator of supply disruptions in the European and American gas markets.
If the European gas crisis worsens in the coming months, the price differential between Dutch TTF and Henry Hub natural gas could widen further, which would likely cause the EUR/USD pair to fall below the parity threshold.
A de-escalation in the Russia-Ukraine conflict, coupled with a decline in the price of Dutch TTF gas, will be a key factor in preventing a further depreciation of the single currency. However, this scenario appears less likely.
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