The fall in euro-US dollar towards parity has been one of the defining moves in financial markets so far this year, reaching its lowest level in 13 years.
Its fall has been more or less a consistent one since the summer of last year, with anticipation of the end of quantitative easing in the US buoying the dollar in the second half of last year. This in turn gave way to expectations that US interest rates would begin rise this year.
However, the real acceleration of euro-dollar decline started in December after the European Central Bank first acknowledged the risk that it would miss its inflation target. The following month, the ECB announced a much more aggressive asset purchase programme than was expected by the markets, in which it promised to buy €1.1 trillion of securities by September next year.
With this prospect forcing the Swiss National Bank to suspend its buying of the euro to defend its euro-Swiss franc currency peg, the euro lost one of its main sources of support over the last few years. This was even before the ECB’s quantitative easing programme took effect. A sharp fall in euro-zone bond yields, many into negative territory, clearly wrong-footed the market, providing another source of pressure on the single currency.
The Greek debt stand-off has been another concern, and it remains unresolved despite the four-month extension of the current loan facility.
The fact that the euro has now almost reached parity with the greenback has actually raised interest rates, and only as the ECB has just begun QE, suggests that the risks are that it will fall further still, even to below parity over the coming year. The experience of QE in the US was that the dollar was pressured over the lifetime of the three asset-purchase programmes and was only able to start rallying as they came to an end.
In terms of the other major currencies – the dollar, yen and sterling – the euro is now easily the one with the lowest interest rates, meaning that it will also be the favoured currency for funding carry trades.
It will also become the borrowing currency of choice in international bond markets. Although the euro’s relative cheapness will potentially encourage capital inflow into European equity markets, the likelihood is that the associated currency risk will be hedged, limiting the potential upside to the euro from such purchases.
The US side of the euro-dollar equation is equally persuasive that the greenback will appreciate further in coming months. Last week the Federal Reserve went further towards preparing the markets for an interest-rate increase by indicating that it was no longer “patient” about normalising monetary policy. Whether the first rise in rates happens in June or September is beside the point, as even after the Fed’s revised forecasts the trend in interest rates is likely to be up, albeit more gradually.
Such divergent monetary policies can be expected to exert pressure on euro-dollar over the coming months, and potentially as far out as late 2016, when the ECB’s quantitative easing is expected to end.
The ECB president, Mario Draghi, has even implied that QE could be extended beyond this deadline if inflation takes longer to respond.
However, the euro is not only at risk from easy ECB monetary policy and normalising Fed policy. The rogue element that could drive it lower still remains Greece and the potential for a messy euro break-up. This risk has not gone away as a result of the agreement between Greece and the rest of the euro zone in late February.
If talks break down over the reforms that Greece is proposing, there is a clear risk of a liquidity crisis leading to a Greek default. It is highly unlikely that such a scenario would be a self-contained event, and contagion would probably spread to the rest of the euro zone, especially given the rising levels of anti-euro political sentiment in countries such as France.
Over its lifetime, the euro has seen fallen to as low as 0.80 cents against the dollar in the first few years of its existence before recovering to 1.60 about the time that QE began in the US. In this context, parity is probably only a staging post on the way to retesting these historically lower levels should macroeconomic divergence continue, and especially if it coincides with the reopening of the euro’s inherent structural flaws.
Tim Fox is the head of research and the chief economist at Emirates NBD.
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