Europe is running short of gas. Where next for EUR/AUD?

The fundamental reason for a currency strengthening is higher demand and lower supply. Interest rates and international trade payments usually govern these.

Higher interest rates make the currency more attractive for short-term cash as banks and investors prefer to park their cash in higher interest currencies.

Higher exports create demand either to buy the traded goods or to change currency earned from exports into local currency.

Currently, the AUD has a significant advantage over the EUR in both areas.

Higher interest rate outlook

The Reserve Bank of Australia (RBA) raised rates four times in a row. Having maintained the cash rate target at a record low of 0.1% since November 2020 , the RBA raised the target rate four months in a row in May, June, July and August 2022. The target rate is now 1.85% and the consensus amongst market commentators is that they will raise rates to between 2.6% and 3.35%. Here’s what the four major banks are forecasting:

• CBA: 2.6% by November 2022
• Westpac: 3.35% by February 2023
• NAB: 2.85% by December 2022
• ANZ: 3% by January 2023

The European Central Bank (ECB) is also raising rates. The ECB announced on July 21 2022 that it would raise its main refinancing rate and deposit rate by 50 basis points to 0.5% and 0.0%, respectively.

Bringing the target rate up to zero from -0.5% marks a significant policy shift. The ECB first introduced negative interest rates in April 2014 and maintained them until July 2022.

Under normal circumstances, the ECB would be able to raise rates in line with the US, which began raising the Federal Reserve discount rate in March and most recently to the current 2.25-2.5% in July.

However, the European economy, led by Germany, is hampered by higher natural gas prices which could send the economy into recession.

Higher coal and natural gas prices

Australia’s top three exports are iron ore, coal, and natural gas. Because of the global coal shortage, coal prices (FOB Newcastle; USD/ton) have soared almost 7-fold from $53.8 three years ago to $358 on 17 August 2022. Similarly, liquefied natural gas (LNG) front-month contract prices for Tokyo delivery are up more than 9-fold from $6 in January 2022 to $56.72 on 17 August this year.

As an exporter of coal and natural gas, higher prices create more demand for Australian dollars.

Meanwhile, the EU had a 137-million-ton coal shortfall in 2021, according to the BP statistical review of world energy 2022.

Europe has a significant energy shortfall

Not only are European gas prices now higher, but they simply can’t import enough to meet demand.

In 2021, the EU imported 49% of its natural gas from Russia through pipelines. Following a series of tit-for-tat sanctions, Russia has all but turned off pipeline gas to Europe.

Last month, Russia’s Gazprom announced that it would reduce gas deliveries via Nord Stream 1, to 33 million cubic metres a day – 20% of the pipeline’s capacity.

Given that the countries most affected by the natural gas shortage don’t have the infrastructure to import enough LNG to replace Russian gas, several countries now have a gas shortage. Importantly, this includes Germany, which is widely seen as the economic powerhouse of Europe.

Economic slowdown means fewer exports for Europe

The shortage of natural gas and resulting high natural gas prices are hitting chemical industries reliant upon natural gas.

BASF SE, which had already reduced ammonia production, announced further cuts in July 2022 and warned that this would send fertilizer prices even higher next year.

Other ammonia producers may follow suit, with Fertiliser giant Yara International ASA, currently 27% below capacity due to the surge in gas prices.

Ammonia is used in fertiliser and chemicals, while the by-product CO2 is used in food production and agriculture. This may impact prices through the supply chain and exacerbate the economic impact.

How high could the Aussie dollar go?

Historically, the Australian dollar has traded between 55 and 75 euro cents, only exceeding that range in the 2012 commodity boom and the 2008 global financial crisis.

As of August 17, the AUD/EUR is trading at 68.2, up 6.7% year to date.

If the above analysis and assumptions are correct, and if natural gas prices continue to climb and iron ore prices remain firm, the AUD could continue rising towards 75 euro cents.

A rise in the Aussie dollar against the euro could net a significant windfall with the right trade.

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