The euro (EUR) - Main characteristics

The European Union (EU) was established to create a united territory. It is currently made up of 28 countries, all of which use the euro except for Denmark and Sweden. The EU's monetary policy is dictated by the ECB (European Central Bank).

Due to its economic potential, the EU is the second economic power in the world, with a gross domestic product of around €16 trillion as of 2020. Thanks to its attractive market structure, it is the second most attractive investment place for local and international investors.

In previous years, the EU has struggled to attract foreign direct investment and large capital flows. In fact, it is a major provider of direct investment, and its share accounts for around 46% of capital outflows worldwide, although it only accounts for 18% of inflows. The main reason for this is that American assets have generally performed better. As a result, American assets absorb about 69% of total foreign savings. However, as the EUR becomes a more established currency, its importance as a reserve currency will increase. One of the consequences of this development has been the increase in capital flows to Europe. Until recently, demand for euros was expected to continue to increase in the hope that foreign central banks would engage in further diversification of reserve assets in euros. However, due to the EU's recent economic crisis (extending until 2012), many experts are questioning the viability of the euro and even of the EU. So we cannot yet state that the world will abandon the USD as its leading reserve currency, at least in the coming decade.

Today, the EU's economy is driven by both trade and capital, which means that trade is a fundamental part of the economies that make up Europe. Unlike other major economic powers such as the United States, the EU doesn't have a large trade surplus or deficit. Exports from EU countries represent around 20% of world trade, while imports only account for only 16% of the world's total.

Also, one reason why the EU and its single currency were formed was to have more weight in relation to trade with the US.

• Main export markets: United States, Norway, Japan, Turkey, Russia, Switzerland and China.
• Main import sources: China, Russia, Turkey, Switzerland, Japan and United States.

The EU's economic structure is largely service-oriented. As of 2020, services represented over 69% of GDP. Manufacturing activities, however, are largely concentrated in Asian territories, due to the fact that monthly labour wages are far lower.

The EU's increasing presence in worldwide trade has a great effect on the EUR as a reserve currency. For nations that have a high percentage of their reserves in a foreign currency (like the USD), it's important to limit exchange risks as well as transaction costs. Traditionally, most international transactions are in USD, JPY or GBP. Before the euro came into the picture, it didn't make much sense to hold any large amounts of an isolated European currency, so reserves were typically in JPY or USD. AS of 2000, 66% of the world's currency reserves were in USD. Since then, countries have sought to diversify their holdings, and so the EUR became the logical alternative - or complement - to USD holdings.

Although Europe is now a major worldwide player, because of recent economic crises that have hit hard, the USD is believed to remain the leading reserve currency for at least another decade.

Main features of the EUR (euro)

As the EUR/USD is the world's most liquid pair, its price movements are a leading indicator of the US and Europe's respective economic states.

The EUR/CHF and EUR/JPY and pairs are also liquid and reflect the economic situation of Switzerland and Japan, respectively. However, the EUR/GBP and EUR/USD are easier to predict and traders benefit from tighter spreads.

Euro risks are more specific

As the euro doesn't have as rich a history as the GBP or the USD, it features some risks that the other 2 currencies don't have. One in particular is the European Central Bank's behaviour, which isn't as predictable as, say, the FED in the US.

The EU's constitution contains a number of provisions which allow member countries to avoid sanctions if they don't comply with budget deficit limits. The fact that non-compliance with deficit limits is authorised contributes to increasing distrust of the euro and the ECB, and has even led some countries to consider dropping the euro in favour of their former currency

In addition, since most European nations use the euro, it's very sensitive to the political and economic stability of these nations. As of 2020, the biggest nations whose national currency is the euro are Spain, Italy, France and Germany..

The spread between 10-year U.S. T-bills and 10-year German bonds is indicative of the euro's health

10-year US treasury bonds can help a trader determine the future direction of the EUR/USD. Spreads between these T-bills and 10-year German bond rates are good indicators of euro price movements. When the rates for German bonds (known as Bunds) are higher than the rates for US Treasuries and the spread between the two increases, this implies that the euro is heading upward. Conversely, a narrowing of the spread between US T-bills and German bund rates implies a decline of the euro.

For most traders, the German 10-year bond is the reference bond for the European monetary union.

Forecasts of capital flows in the euro zone

Another interest rate instrument that investors use to figure out the future direction of the euro is the 3-month interest rate, known as the Euribor rate. This is the rate offered by banks for interbank deposits. Forex traders will often compare EUR/USD futures with Euribor futures.

EUR/USD futures contracts are dollar-denominated deposits held in banks and other financial institutions located outside the United States. As traders prefer assets that offer the best ROI, European fixed income instruments become more attractive when the spread between EUR/USD futures and Euribor futures in favour of the latter. When the spread tightens, European assets are less attractive, which implies a possible decrease in capital flows to euro-denominated assets.

Merger and acquisition activities also have a significant effect on EUR/USD price movements. Whenever a major international corporate transaction occurs, this oftentimes leads to a short time price spike on the pair.

The European Central Bank (ECB): in charge of regulating Europe's fiscal and monetary policy

The ECB is the regulatory body that defines the monetary policy of euro-using countries. Its board consists of a president, a vice-president and a few other members. Similarly, its Board of Governors consists of the members of this board as well as each country's central bank president.

Typically, new monetary policy decisions are voted on at meetings held twice a month (the President's vote breaks any tie vote). They will typically hold a press conference when a major policy change is expected.

The ECB's primary objective is to maintain price stability and favour economic growth. Budgetary and monetary decisions are therefore made with these objectives in mind. In terms of inflation, the European Central Bank aims to keep it under 2% per year.

As of 2020, the main tools used by the ECB to implement its monetary policy are:

Open market operations

The ECB has several types of open market adjustment "tools" it can use to manage liquidity, control interest rates and indicate its monetary policy position.

• Primary refinancing transactions: these are regular temporary sell-off transactions that provide liquidity. These transactions are carried out weekly and only last 14 days. They provide the financial sector with its greatest percentage of refinancing.
• Longer-term refinancing transactions: these are temporary sell-off transactions that provide liquidity. They are carried out every month and last around 90 days, which allows the two counterparties to benefit from additional longer-term refinancing.
• Adjustment transactions: these are operations carried out on a case-by-case basis, with the aim of managing the market's liquidity situation and increasing or decreasing interest rates. Here, the effect of unexpected fluctuations in liquidity on these transactions (interest rates) must be moderate.
• Structural transactions: these transactions consist of the issuance of debt certificates, permanent transactions of various types and reverse transactions. These operations are carried out whenever it is beneficial to tweak Europe's structural position in terms of the financial sector, whether on a regular basis or not.

ECB minimum bid rate or Repo rate

The main objective of ECB policy is the minimum bid rate or Repo rate. This is the level of debt offered to the various European countries' central banks, as well as the rate that could be modified during the 2 meetings that are held every month. As inflation is one of the most important issues, the ECB is generally more likely to keep interest rates higher in order to avoid a spike in inflation. The changes in the ECB's minimum bid rate have far-reaching ramifications and consequences for the euro.

Regarding the euro exchange rate, Europe's central bank doesn't offer any specific targets, but it does consider this topic when it defines its policy. The central bank can therefore intervene in the forex if it feals that its inflation targets are threatened. Traders thus have to keep their ears peeled for any statements made by the board of governors, as they can cause market prices to move, especially for the bigger euro pairs such as the euro-dollar.

The ECB regularly publishes a bulletin which includes detailed analyses of economic developments and changes in their perception of economic conditions. It is therefore important to read them in order to sniff out any impending changes in the eurozone's monetary policy.