Source: Jeff Yoders/MetalMier
It’s not the first time, but the United States of America and Europe seem to be heading in opposite directions.
In this case, it’s their currencies that are going opposite directions. The U.S. dollar’s rise and the euro’s fall are being driven by policies and perceptions of what those policies mean for growth and prosperity next year. The big questions for firms with business interests in both camps is does this mean we could see parity between the dollar and euro next year?
The euro was last at parity with the dollar in late 2002, but the first half of the decade saw expectations for strong growth in Europe after the financial crisis followed by a flight to safety that maintained a relatively strong euro relative to other currencies.
How the US Dollar Got its Groove Back
While the recovery of the U.S. economy has been somewhat unspectacular, it has at least been steady and heading in the right direction for the last few years. Europe, on the other hand, has been plagued with banking fears, political unrest and slow if not stagnant growth.
As a result, the European Central Bank has embarked on a monetary policy that has pushed rates into negative territory and involved quantitative easing with a huge bond buying program. Expectations of economic growth have jumped following the surprise result of the American presidential election and that has been supporting for the U.S. dollar as President-elect Donald Trump’s promises of infrastructure investment and tax cuts, financed by increased debt, have significantly raised the prospects for early and subsequent Federal Reserve interest rate increases.
What This Means for Euro-Denominated Trades
The euro’s continued decline could be good for European economies as the weaker exchange rate will make the region’s exports more competitive and should encourage inflation, which has remained stubbornly below the ECB’s target of 2%. As the U.K. will find, with the weaker currency, some dollar-denominated imports such as oil and natural gas will rise in cost. Still, few in Europe are likely to object to a more competitive exchange rate.
The euro fell to a low of $1.046 in March on the expectation that the Fed would raise rates at least once or twice during 2016. In practice that hasn’t happened, resulting in a minor retrenchment. Now, the euro is likely to plumb those depths and more in 2017 as the Fed is expected to raise rates in December and it’s contemplating, according to Goldman Sachs, a further three rate increases in 2017.
Not everyone however is in agreement that parity is a certainty in 2017. A Wall Street Journal article quotes Jeffrey Yu, head of the U.K. investments office at UBS Wealth Management saying “If you just look at how the euro-zone has performed in terms of data, things look better than they did the last time people were gunning for parity.”
The euro-zone economy has grown slowly but consistently for each of the last nine quarters, expanding by between 0.3% and 0.8% of gross domestic product every three months. The euro’s weakness is not just down to the economy. Doubts exist about the political robustness of the European model. This year, the United Kingdom voted to leave the European Union in a shock June referendum. Next year will see elections in France, the Netherlands, Germany and a host of smaller states with populist, largely anti-globalization parties coming to the fore. Continued modest growth is by no means a certainty, but anxiety driven by this uncertainty is weighing on the euro and driving its decline against the dollar.
For firms selling into the European market, forward hedging may be a prudent move. For those sourcing or buying from — or exposed to euro-priced supplies — look out for cost reduction opportunities if the currencies continue toward parity.