The tensions in the Red Sea could produce the same sort of energy and terms of trade effects, so imperilling the euro

There’s a lot for financial markets to be anxious about this year but the factor that seems to be number one on the wall of worry at the moment is the situation in the Red Sea. So far, it has not materially upset the stability in the FX market, but this could change.

One very obvious point about currencies is that their movement should, in theory at least, be based on relatives, not absolutes. A strong growth rate or a rise in interest rates in one country might seem like the sort of ‘absolute’ change that can drive currency strength, but it won’t if, in relative terms, another country is growing much faster and hiking rates much more.

To give an example, the pandemic did not have huge relative connotations, only absolute reverberations. In other words, everyone was impacted to a similar extent and hence currencies did not move very much. As another example, central banks have hiked rates by a huge amount in absolute terms in recent years but not in relative terms and hence G10 currencies have not moved dramatically, apart from the yen where there have been large relative changes.

As an example of relative change, if we think about the war in Ukraine, this led to a surge in European energy prices relative to the US, with the resultant deterioration in the Euro zone and UK terms of trade relative to the US pushing the euro and pound down substantially (the chart is on page 4).

This last example clearly shows that significant movement in the terms of trade can have a bearing on currencies, particularly when the adjustments occur because of an unanticipated shock, like the war in Ukraine. The question today is whether the tensions in the Red Sea could produce the same sort of energy and terms of trade effects, so imperilling the euro – and other European currencies as well - against the dollar. The adverse impact on Europe occurs because a notable proportion of its trade comes through the Red Sea route. In global term some 12% of seaborne oil trade goes through the Red Sea and 8% of liquified natural gas.

Given that Europe was forced by the war in Ukraine to source its energy supply away from Russia to the likes of Norway – and the global south – the tensions in the Red Sea could potentially weigh much more on Europe than the US, and not, incidentally, just in terms of energy, but other goods as well. In theory, at least, this could prove another nasty terms of trade shock for Europe that weighs on the euro and other European currencies against the dollar, and perhaps others as well, like the yen.

However, so far at least that’s not how things are playing out because Europe has long since seemingly secured all the energy supplies that it has required for the winter period. Of course, this could change depending on how mild or cold the winter turns out to be but, so far at least, European gas prices have been falling through this conflict, not rising.

A bigger issue could develop further down the track as Europe tries to secure sufficient low-cost energy supplies for next winter, should the conflict in the Red Sea persist and escalate. Even before then there is still the issue of whether the Red Sea tensions will lift prices more generally in Europe relative to the US as extra costs are incurred to re-route ships from Asia. Again, in theory, at least, if this does happen it could forestall ECB easing as short-term inflationary pressure picks back up.

Meanwhile, if the Fed is still able to push ahead with rate cuts then this might theoretically lift euro/dollar, not weaken it. However, for our part we don’t think that this ‘relative’ easing of policy by the Fed would be sufficient to lift euro/dollar significantly and we are also sceptical that the ECB would delay rate cuts by much anyway.

One reason for this is that we have to bear in mind that the euro zone is already staring down the barrel of a recession and a further hit to real incomes from a new spurt in inflation could make a bad situation materially worse and, in our view, that’s not good for the euro. Hence, in conclusion, as long as this Red Sea uncertainty lingers we would err to the bearish side for the euro against the dollar.