What does this mean for investors as the pair approaches parity?

The euro sign sculpture stands in front of the former headquarters of the European Central Bank (ECB) in Frankfurt, Germany, Sunday, July 3, 2016.

Krisztian Bocsi | Bloomberg | Getty Images

The euro is approaching parity with the US dollar for the first time in 20 years, but currency strategists are divided on whether it will get there and what it will mean for investors and the economy.

On Thursday morning in Europe, the euro was hovering around $1.05, after falling steadily for nearly a year from around $1.22 last June. The common currency slipped just above $1.03 earlier this week.

The dollar was bolstered by risk aversion in the markets as concerns over Russia’s war in Ukraine, soaring inflation, supply chain issues, slowing growth and tightening monetary policy pushed investors into traditional “safe haven” assets.

The tightening between the two currencies was also driven by the divergence in monetary policies between central banks. Earlier this month, the US Federal Reserve raised benchmark borrowing rates by half a percentage point, its second hike of 2022, as it seeks to contain inflation at its highest level. for 40 years.

Fed Chairman Jerome Powell said on Tuesday that the central bank would not hesitate to continue raising rates until inflation returns to a manageable level and reiterated his commitment to bringing it closer to the Fed’s 2% target.

The European Central Bank, unlike the Fed and the Bank of England, has yet to raise interest rates despite record inflation in the eurozone. However, it has signaled the end of its asset purchase program and policymakers have recently adopted a more hawkish tone.

ECB policy chief Francois Villeroy de Galhau said on Monday that excessive euro weakness was threatening price stability in the bloc, raising the cost of imported dollar-denominated goods and raw materials and fueling further pressures. on prices that have pushed eurozone inflation to record highs.

What would it take to achieve parity?

Sam Zief, global head of FX strategy at JPMorgan Private Bank, told CNBC on Wednesday that the path to parity would require “a downgrade in growth expectations for the eurozone relative to the United States, similar to what which we got immediately after the Ukrainian invasion.”

“Is it possible? Sure, but it’s definitely not our base case, and even then it looks like the euro at par becomes your worst-case scenario,” Zief said.

He suggested that the risk-reward ratio over a two- to three-year period – with the ECB likely escaping negative rate territory and less fixed-income outflows from the euro zone – means the euro looks “incredibly good. market” at present.

“I don’t think there are many customers who are going to look back in two or three years and think that buying euros at less than $1.05 was a bad idea,” Zief said.

He noted that the aggressive cycle of interest rate hikes and quantitative tightening by the Fed over the next two years are already priced into the dollar, a view shared by European head of strategy Stephen Gallo. FX at BMO Capital Markets.

Gallo also told CNBC via email that it’s not just the prospect of a significant policy divergence between the Fed and the ECB that will affect the EURUSD pair.

“It’s also the evolution of core euro balance of payments flows and the prospect of additional negative energy supply shocks that are also dragging the currency down,” he said. .

“We haven’t seen evidence of a significant build-up of short EURUSD positions from leveraged funds in the data we track, leading us to believe the euro is weak in due to a deterioration of the underlying base flows.”

A move to parity between the euro and the dollar, suggested Gallo, would require “policy inertia” from the ECB over the summer, in the form of rates remaining unchanged, and a full German embargo on Russian imports. of fossil fuels, which would lead to energy rationing. .

“It would not be surprising to see the ECB’s policy inertia continue if the central bank faces the worst possible combination of higher recession risk in Germany and additional sharp price increases (that’s i.e. the dreaded stagnation),” Gallo said.

“For the Fed’s part in all of this, I think the Fed would be alarmed by a move towards the EURUSD 0.98-1.02 range, and that magnitude of USD strength relative to the ‘EUR, and I could see a move towards that EURUSD zone causing the Fed to suspend or slow down its tightening campaign.”

Dollar “too high”

The dollar index is up about 8% year-to-date, and in a note Tuesday, Deutsche Bank said the “safe haven” risk premium valued in the greenback now stands at ” upper end of the extremes”, even taking into account interest rate differentials.

Deutsche Bank’s global co-head of FX research, George Saravelos, believes a turning point is near. He argued that we are now at a stage where further deterioration in financial conditions is “undermining Fed tightening expectations” while there is much more tightening to come for the rest of the world, and Europe in particular. particular.

“We don’t believe Europe is on the verge of a recession and European data – contrary to consensus rhetoric – continues to outperform the US,” Saravelos said.

Deutsche Bank’s valuation monitor says the US dollar is now the ‘most expensive currency in the world’, while the German lender’s currency positioning indicator shows long dollar positions against market currencies emerging markets are at their highest level since the peak of the Covid-19 pandemic.

“All of these things send the same message: the dollar is too high,” Saravelos concluded. “Our forecasts imply that EUR/USD will rally to 1.10 and not parity in the coming months.”

The case of parity

While many analysts remain skeptical of parity, at least persistently, pockets of the market still believe that the euro will eventually weaken further.

Interest rate differentials vis-à-vis the United States moved against the euro after the June 2021 Fed meeting, during which policymakers signaled an increasingly aggressive pace tightening policies.

Jonas Goltermann, senior market economist at Capital Economics, said in a note last week that the ECB’s recent hawkish turn still hasn’t matched the Fed or been enough to offset rising expectations. inflation in the euro area since the beginning of 2022.

While Capital Economics expects the policy trajectory for the Fed to be similar to that priced in by the markets, Goltermann expects a less aggressive trajectory than discounted for the ECB, implying a further shift in spreads. nominal interest rates against the euro, although much lower than that. seen last June.

Deteriorating eurozone terms of trade and a global economic slowdown with further turbulence ahead – with the euro more exposed to financial tightening due to the vulnerability of its peripheral bond markets – further worsen this view.

“The result is that – unlike most other analysts – we expect the euro to weaken a little further against the dollar: we expect the EUR/USD rate to reach parity later this year, before rebounding towards 1.10 in 2023 as headwinds to the eurozone economy ease and the Fed reaches the end of its tightening cycle,” Goltermann said.

By cardgo

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