EUR / USD exchange: causes and effects, risks and opportunities.

Politics - September 19, 2022

The Euro / Dollar exchange rate (EURO/ USD) in recent sessions continues to trace a medium-term negative trend to the advantage of the dollar. The EUR / USD exchange rate went from 1.14 at the beginning of the year to levels below the parity that we had not seen for twenty years, an important share also on a psychological level. The EUR / USD exchange rate on 25 August 2022 touched 0.9985.

The EUR / USD parity is in the spotlight in all the global currency markets. We need to go back to the period of the dotcom crisis (2000-2002) to see levels like these when, on this occasion, the exchange rate touched an all-time low of 0.82 and the stress on the single currency is, mainly due now, to energy pressures. It is a moment of uncertainty for Europe both due to inflation caused by supply shocks (due to energy costs), and by economic instability, consequently the differential between the euro rates against the dollar has been increasing (as explained below).

The technical analysis shows support levels to be monitored are on the EURO / USD parity and around the 0.98 area while the upside, however, the resistance levels of the 1.05 area should be observed.

The problem of these levels is also linked to the high number of speculative positions on the strengthening of the “net long” dollar, even if they have not yet reached excessive volumes. The low probability of resolution of geopolitical tensions and the continuing uncertainties on rate increases, do nothing but favor the dollar as a currency/safe haven.

Fed President Jerome Powell, in a not too long speech at the Jackson Hole Economic Policy Symposium in 2022 “Reassessing Constraints on the Economy and Policy”, was very precise in reiterating his messages: “Bringing back the stability of pricing will take time and large use of our tools to balance supply and demand. Reducing inflation down to 2% will likely require a period of under-trend growth.” The markets did not like these utterances very much, as they awaited a more optimistic attitude, especially according to the slightly improving data recorded in July. These interventions to attack consumption is justified by the fact that, while in cases of inflation caused by demand shocks, restrictive monetary policies (increase in interest rates) have an almost immediate effect, in the current case, on the other hand, to lower inflation levels from supply, rate increases alone cannot be enough but demand must be aligned with supply and the only way to do that is to cool the demand itself. For Europe, in particular, the supply shock is even more marked, being completely exogenous, due to therefore, the ECB’s rate hike serves to control inflation expectations against the energy shock. The ECB picture is more complex than the Fed’s tightening strategy, which is why in a moment of volatility and uncertainty the advantage for the dollar is fueled.

This article attempts to summarize the causes and effects of the current EURO/ USD exchange rate from a macroeconomic point of view.

Europe, since the beginning of the year, has been at the center of economic and geopolitical issues due to the Russia-Ukraine conflict. The dependence of Europe on Russian gas, in particular of Germany, has highlighted the strong difference in supplies with the rest of the world, leading to a sharp increase in energy prices and consequent greater burdens for households and industry. In summary, the current situation can only allow us to hypothesize an inevitable negative growth scenario. Think, for example, of the macro data published by Germany in which there is the first monthly trade deficit since 1991 due to high import costs and lower export demand.

From the side of the financial and currency markets, this situation offers operational insights into the repositioning of financial portfolios, in view of a probable European recession that the markets already seem to be discounting and weighs on these declines, the strong and lasting pressure of gas rationing, more generally of commodity price increases.

On the EU front, there is a concern about this risk and the various tactical and strategic solutions to be implemented to combat these blows to businesses and consumers are being considered, as it scares the specter of a possible stagflation.

The supply shock due to the increase in production costs and the increase in inflation, slow down growth in Europe, thus leading to a weakening of the euro against the dollar.

As for the situation of the US dollar, on the other hand, it is known that the US economy has greater levels of autonomy on the energy and raw materials front, especially natural gas. Therefore, in the face of a global economy in strong slowdown since the beginning of the year, due to a surge in inflation, the restrictive policies of the central banks and the Russian-Ukrainian conflict that does not seem to stop easily, the concern of investors pushes them to shift their interest towards the safe haven currency par excellence, the US dollar, accumulating liquidity. However, these are just some of the reasons that justify its appreciation, in fact, even the particularly restrictive monetary policy of the Fed, whose interest rate increase aims to control inflation as quickly as possible, has contributed to widening the dollar-euro differential.

The most frequently asked question among industry experts is certainly related to the potential strength of the US dollar. Nobody knows how far the strength of the US currency will go but the economic data must be analyzed from time to time. In this regard, the US inflation and employment data will be interesting, which will help decide the intensity and speed of the subsequent rate hikes by the Fed.

The interventions of the Central Banks highlight a divergence in the approach to the implementation of the monetary policy of the Federal Reserve compared to the European Central Bank. Surely, the objective of both Central Banks is to implement all the tactics in their possession to regain control of inflation. In the case of the United States, only a probable weakening of economic growth and a drop in inflation could lead the Fed to ease its restrictive policy but, until then, the dollar should maintain such high levels.

Focusing instead on the weakness of the euro, some effects of this condition should be pointed out, such as the positive one linked to exports: with a weak currency you can export more easily, favoring the competitiveness of European companies.

The only problem obviously remains inflation, the increase of which could absorb this positive effect of monetary exchange. Compared to the EURO / USD exchange rate examined so far, it should be remembered that the United States represented in 2021 for Italy, for example, the third destination market for the export of the fashion, accessories, mechanics and agri-food sectors, for a value of approximately sixty billion dollars but, on the other hand, of course, imports are more expensive. In this precise context, the price increases not only for US hi-tech products, but also for energy supplies. Think, for example, of the purchase of oil, whose price per barrel is expressed in dollars and again, thinking about supply alternatives, the hypotheses that circulate are to compensate for the reductions in Russian gas supplies, with imports of liquid gas from the United States, paying it, obviously, in dollars.

In conclusion, the consequences of the EURO / USD exchange rate also have repercussions on the tourism sector such as travel facilities, accommodation and purchases for Americans in Europe. An advantage certainly emerges in favor of Europe which, with the resumption of tourist flows, signals economic benefits for the related industries.

Author: Katia Franchitto