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Fourth wave will hammer the euro and drag Europe into a recession

Austria has been locked down from the start of this week. The riot police are out in force to control protests in the Netherlands. And Germany is closing region by region.

A deadly fourth wave of COVID-19 is ripping across continental Europe, filling up hospitals, and putting health systems under strain. That is, of course, mainly a health emergency.

And yet, it is very quickly going to turn into an economic emergency as well – and one that will hit the tumbling euro hard. The euro is already falling sharply on the currency market. But that is about to get a lot worse.

Why? Because growth will inevitably stall as fresh restrictions are imposed, especially in Germany.

Because the European Central Bank was already diverging sharply from its peers, but that gulf will get wider and wider.

And because debt levels will inevitably rise from already stretched levels, while policymakers are left paralysed, and the EU coronavirus rescue fund will be exposed as pitifully inadequate given the scale of the challenge.

Add it all up, and the fourth wave will hammer both the economy and the currency – and may well send the euro all the way down to parity with the dollar.

The fourth wave of COVID-19 across Europe has caught governments hopelessly unprepared.

Relatively low vaccination rates, a tragic legacy of the European Union’s botched procurement of inoculations last winter, coupled with waning immunity, has led to a dangerous spike in both infections and hospital admissions.

Austria went back into lockdown on Monday and will make vaccination compulsory from February. Belgium and the Netherlands are imposing restrictions, leading to riots in the streets.

Most significantly of all, there are regional restrictions in Germany, with daily infections soaring past 60,000, and there could be a full national lockdown very soon.

We know from the last two years how that will damage the economy. “Let there be no doubt,” warned High-Frequency Economics in a note published on Monday.

“If Germany’s economy locks down the Euroland economy will relapse into recession.”

No one could seriously dispute that verdict. Lockdowns lead to downturns for the simple reason that closed factories don’t make anything and shuttered restaurants don’t serve any meals. The first lockdown took 14.8pc off the zone’s GDP, and while this latest one may not be quite so bad, the hit will inevitably be substantial.

The impact of that can already be seen in the currency market.

Over the last couple of weeks, as infections started rising, the euro has been falling sharply. From 1.22 to the dollar, it has dropped to 1.12, its lowest level in years.

And yet, investors are going to keep selling off the currency – for three reasons.

First, growth will stall as economies are closed down again.

The fourth wave may be concentrated in Germany, Austria, and the Benelux zone – Southern Europe is much-maligned but has coped far better – but the hit to output will spread far wider.

Since the single currency was launched, the historical correlation between the GDP of Germany and the wider eurozone is 0.96.

In short, if Germany sinks, so does the whole zone.

The economy of the entire continent will suffer, even if restaurants and bars in Spain and Italy manage to stay open through the winter – the downturn in Germany will dominate everything.

Next, the ECB was already diverging on policy from other major central banks. The Federal Reserve has turned most hawkish, gradually winding up quantitative easing, and mapping out a path to higher interest rates (with inflation already above 6pc it doesn’t have much choice).

The Bank of England may have blinked last month, but it is likely to start increasing rates soon. Minor central banks in Europe are already hiking, with both the Polish and the Czech central banks raising rates this month, the Czechs to the highest levels since the 2008 crash.

Against that backdrop, the ECB will be holding rates at close to zero, and may have to ramp up QE even further. It will be easing policy while others are tightening, hitting the currency hard.

Even worse, it will be forced to ignore rising inflation – already over 4pc in Germany – and risks letting it run out of control.

Finally, policy will be paralysed.

Germany still doesn’t have a coalition government after a messy election in September, and France is heading into a fraught presidential election, which means no hard decisions will be made until next spring.

The €750bn (£630bn) coronavirus rescue fund launched by the EU in the wake of the first wave may sound like a lot of money, but it is puny compared to the scale of the eurozone economy.

In addition, no one has yet decided how all the extra debt will ever be repaid and there is zero chance of the size of the fund increasing to cope with a fresh downturn.

It will be exposed as hopelessly inadequate as half the continent heads back into a winter lockdown.

The euro was already slipping on the currency markets as the continent struggled to recover from the pandemic at the same rate as other major regions (similarly to the UK, of course).

In a repeat of the 2008 crash, recessions are deeper, and last longer, and recoveries weaker, in the eurozone than anywhere else.

Each time that happens, the zone’s economy grows a little more feeble.

As the fourth wave picks up momentum, and as either regional or national lockdowns are imposed, it will hammer the currency, potentially taking it all the way down to parity with the dollar, a level it briefly broke after a chaotic launch, but has not breached for almost 20 years.

And the whole zone will be dragged down into a recession, coupled with dangerously high inflation, from which it will take years to recover.

Source: Matthew Lynn – The Telegraph