Why the euro fell close to parity with the US dollar
1. Why is the euro sinking?
Europe is suffering the most from the war, which has triggered an energy crisis and could lead to a long and deep recession. This puts the ECB in a difficult position – trying to rein in inflation and cushion the slowing economy – as it aims to raise borrowing costs for the first time since 2011. At the same time, the Reserve US federal government raises interest rates much faster. than the euro zone to 19 nations. This makes yields on US Treasuries higher than those on European debt, pushing investors toward the dollar and away from the euro. Additionally, the greenback benefits from its safe-haven status, which means that as the war drags on and the fallout worsens, the euro continues to decline.
2. Why is a weaker currency bad?
For years, policymakers have welcomed a weaker currency as a way to boost economic growth because it makes the bloc’s exports more competitive. But now, with inflation in the euro zone at its highest since these records began, its weakness is undesirable as it stokes price increases by making imports more expensive. In June, consumer prices in the euro zone jumped 8.6% compared to the previous year. Some policymakers have pointed to a weaker euro as a risk to the central bank’s goal of bringing inflation down to 2% over the medium term, although the ECB is not targeting the exchange rate. Yet, when measured against other currencies outside the dollar, the euro appears more resilient.
3. Does the 1:1 level matter?
Yes. This is a psychological threshold for the market. The first time the euro fell to parity with the dollar was in December 1999, not even a year after its creation. Just like today, analysts then pointed to a widening spread between German and US bond yields and stronger US growth. It was a breach in the pride of Europeans, who saw in the common currency an important political project and a rival to the dominant dollar. Today, the euro is considered one of the world’s main currencies for transactions and reserves, even if reaching parity remains symbolic. For the financial markets, currency traders expect turbulence around the 1:1 level as billions of euros in options bets are tied to this big line in the sand.
4. Where is the ground?
It’s hard to say. Some analysts have predicted the common currency could drop to 90 US cents if Russia escalates the crisis by denying more gas supplies to Europe. Since the start of July, options traders have been placing more bets around the $0.95 level, with $0.9850 potentially acting as a short-term low, according to trade data from the Depository Trust & Clearing Corporation. Deutsche Bank strategists calculated that a drop to $0.95-$0.97 would match the all-time extremes seen in exchange rates since the 1971 end of the so-called Bretton Woods system, which tied the value of many currencies to the US dollar. Still, those levels could well be reached in a recession, they said.
5. What could trigger a reversal?
The key is to narrow the interest rate differential with other global bond markets. When the Fed had delivered 150 basis points of interest rate hikes in just three months, the ECB had not moved yet, keeping its key rate negative. As European rate setters have signaled the start of their hike cycle — including a potential 50 basis point hike in September — doubts are mounting over how long they can sustain it. Raising rates is more difficult for the ECB than for other central banks. Indeed, the borrowing costs of the most indebted countries in the euro zone risk spiraling out of control if investors begin to question their ability to bear the debt burden. Even the hint that policymakers were planning to tighten policy faster than some expected in June sent Italy’s 10-year yield jumping above 4% for the first time since 2014. Since then, investors were more or less reassured by promises of a new tool to prevent unwarranted spikes in bond yields. But if this plan disappoints the markets, they might begin to doubt the extent of the tightening the ECB is ready to offer.
Read more: Why the ECB needs new tools for bond ‘fragmentation’: QuickTake
6. Is this an existential crisis for the euro?
No, although apart from the pressure on its value, the common currency has faced challenges as a concept in the past. Since its formation, opponents have pointed to the difficulties of managing a monetary union of disparate economies. This became evident during the Eurozone sovereign debt crisis in 2012, as investors began to avoid assets from more indebted countries such as Greece, Italy and Spain. The rise of Eurosceptic politicians in Italy and elsewhere has also raised concerns about the bloc’s resilience. A watershed moment came in July 2012, when ECB President Mario Draghi pledged to do “whatever it takes” to save the common currency. Yet direct interventions to support the euro in foreign exchange markets are rare, although central banks took action in 2000.
More stories like this are available at bloomberg.com