EUR/USD: Goldman Sachs Predicts Crash in Euro to Dollar Exchange Rate

EUR USDGoldman Sachs Forecasts Parity in Euro to Dollar

As we approach the Federal Reserve’s meeting on whether or not to raise interest rates, a long list of banks are making their predictions about where the euro to dollar outlook is headed. Goldman Sachs, the smartest of the smart money, is predicting the EUR/USD will reach parity by the fourth quarter of 2016. (Source: “Banks Ease Expectations of Euro-Dollar Parity,” The Wall Street Journal, December 10, 2015.)

I agree.

The euro to dollar exchange rate took a dip in the weeks leading up to a meeting of the European Central Bank (ECB), as markets expected another bout of monetary stimulus. Investors knew that further stimulus would weaken the euro.

However, the ECB’s actions fell short of expectations. The EUR/USD bounced back when it became obvious that markets had overestimated the central bank’s willingness to support European exports, but this bump in the euro is just temporary.

The Federal Reserve is meeting next week and it is expected, by all accounts, to raise interest rates. A rate hike would finally close the book on the financial crisis, sending the dollar soaring against the euro. That’s how Goldman Sachs sees this scenario playing out.

EUR/USD Could Be Even by End of 2016

A lot of investment banks mistakenly assume the ECB’s reluctant stimulus can prop up the euro for all of 2016, but the folks over at Goldman Sachs are too savvy to fall for that head fake. They know how this game is played.

ECB President Mario Draghi is no fool; he knows that the Federal Reserve is likely to raise interest rates and that this would strengthen the U.S. dollar. So why would he create a stimulus package to achieve the same effect when it will happen regardless?

While the logic of that argument is sound, it fails to account for the most important thing in central banking: market expectations. Investors were convinced the euro to dollar exchange rate would drop and that affected their behavior.

Now, they don’t know what to expect. Confusion over a central bank’s intentions usually leads to panic, especially when the underlying economy is weak.

So let’s game out this situation: The Fed hikes interest rates and the euro to dollar plummets. Econ 101 tells us the weak euro will help push up exports, but that doesn’t happen overnight. What will happen instantly is that European purchasing power will take a hit, prompting many people to cut back on spending. That’s more money out of the economy. The release of economic figures in Europe will probably make things worse, because they could feed into a narrative of European decline. Meanwhile, the U.S. dollar could surge off optimism that America has fully recovered from its post-crisis woes.

The ECB Just Lost Control of the Euro

I think that moment will be remembered as a huge mistake. Mario Draghi’s hesitation could be the undoing of the euro, simply because it warped investor expectations. After the calamitous situation in Greece this past summer, European investors needed a boost of optimism from their central bank.

They didn’t get any and as a result, the euro to dollar will continue dropping through 2016. It will be a painful road, but hopefully the hardship caused by a weak euro will compel European lawmakers to adopt growth-friendly reforms.

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