18.07.2022 Finance Luxembourg

A tale of two currencies

The euro has reached its lowest level vs. the US dollar since 2002. What’s behind the falling value of the common currency?

This week, the euro reached parity vs. the US dollar for the first time in two decades, having lost one-fifth of its value against the greenback since the start of this year. The common currency, introduced in 1999 and worth an average of $1.18 over the past decade, is now way off its 2008 peak of nearly $1.60.

Today, however, it’s not just the euro that’s falling against the greenback. The US Dollar Index – which tracks the performance of the USD vs. a basket of major currencies (including the euro, yen, Swiss franc, Canadian dollar, pound sterling and Swedish krona) – has been climbing steadily since the start of 2022. That index is now up roughly 20% since January, mirroring the euro trend.

So before looking at the weakness of the common currency, it’s worth first asking why the dollar is currently so strong.

US unemployment is holding steady at very low rates, standing at 3.6% in June, but real average hourly earnings are falling due to inflation. Indeed, US inflation has soared to 40-year highs – led by gas, food and housing costs – and consumer confidence has reached the lowest level in 16 months, closely linked to inflation concerns. The International Monetary Fund recently warned of potential sustained lower US growth and higher unemployment. Talk of a possible recession continues to get louder.

On the other side of the Atlantic, euro area unemployment, at 6.6%, is almost twice as high as in the US, and inflation is likewise soaring. Just as in the US, European consumer confidence is in the basement. Recession worries are even more pronounced in Europe, especially given the more direct economic consequences of the war in Ukraine, including far greater dependency on Russian oil and natural gas.

So does the falling euro and rising dollar simply reflect the fact that, while the US economy appears increasingly fragile, the outlook for the eurozone is even worse? Partly, but it’s not that simple.

Americans and Europeans don’t just dress and eat differently; they also diverge significantly when it comes to monetary policy. In the United States, the Federal Reserve has been aggressively raising interest rates – demonstrating its willingness to risk a “policy mistake” in the pursuit of lower inflation – and reducing the size of its balance sheet. While we expect the European Central Bank to start hiking next week, it will clearly be on a far less aggressive path relative to the Fed.

Add to that the widening transatlantic interest-rate differential (the ECB’s key policy rate is still in negative territory, while the Fed has hiked by a cumulative 150 basis points). The ongoing energy shock is also already negatively impacting trade balances in Europe – the German trade balance has shrunk into deficit for the first time since 1991 – which is not helping the euro. Last but not least, geopolitical uncertainty – including zero-Covid policies in China – will continue to support safe-haven flows to the US, a trend unlikely to be reversed in the near term.

Put all these factors together and it’s very difficult to be bullish on the common currency, at least for the next few months. That’s obviously good news for euro area-based exporters and souvenir hawkers across the continent. Because this summer, inevitable flight delays notwithstanding, rest assured that American tourists will be snapping up Eiffel Tower trinkets by the armload and as much knockoff Venetian glassware as they can carry.

Source: Daniele Antonucci, from Quintet Private Bank