EURUSD: This Could Crush the Euro to Dollar Exchange Rate

Euro to USDThere is a greater chance for euro to dollar parity as Europe, which was gaining some strength since December, is weakening again.

Mario Draghi and the European Central Bank (ECB) have triggered a recovery in European markets in the last week of January, promising new ideas ahead of the U.S. Federal Reserve’s decision. International tensions invite caution and it is unlikely that the Fed will put additional pressure on world markets by propping up the U.S. dollar further and putting more pressure against the euro.

Even if the Fed should be very prudent in its announced cycle of rising interest rates, the underlying trend of monetary policy tightening in the United States and easing in Europe, as well as probably Japan and China, will be the trend for the foreseeable future.

Mario Draghi’s hints toward easing the ECB’s already easy (“accommodating” would be too conservative a description) policy has sent the euro into reflux mode after it showed some signs of recuperating territory against the U.S. dollar. For the month of March, the European currency has indeed begun a reflux movement. The euro fell by 0.7% on Friday to trade at $1.0794, a decline of about 1.5% for the week ($1.0952 on Friday, January 15).

The ECB’s monetary expansion promises came as oil prices were rebounding, met by a corresponding bounce in world stock markets on January 22. At the end of 2015, many analysts saw the euro decline for a short term to reach parity with the dollar, but this January’s market volatility had started to put this scenario in doubt. (Source: “Draghi Promises Gifts But Turns Up Bearing Coal,” MarketPulse, December 3, 2015.)

The phenomenon of flight, prompted by uncertainty, toward safer assets made currencies such as the euro, the yen—gold, which went up some four percent since the start of 2016—benefited from a kind of “safe haven” effect.

In addition, the euro found some support in recent weeks by the disappointment related to the previous ECB meeting on December 3. The institution had announced a lower-than-expected extension of its asset purchase, which caused a sharp rebound of the single European currency.

This Could Crush the EURUSD

More quantitative easing (QE) points the euro in a bearish direction. If there is an argument against EUR/USD parity it is that while the ECB seems ready to act to strengthen its “QE,” weakening the European currency, the Fed may have to slow the pace of its future rate hikes, which would weigh on the dollar.

Indeed, the latest U.S. statistics were disappointing (weekly unemployment, inflation, housing starts…), which could fuel fears that the slowdown in the Chinese economy is affecting the United States and the rest of the world.

While in mid-December, after the first increase in the Fed’s key rate in nearly 10 years, analysts were expecting four additional quarter-point increases in 2016. They are now likely to agree the global economic slowdown may reduce this to two or even one, which will deflate the U.S. dollar’s appreciation somewhat. Nevertheless, should statistics be especially bullish next March, the Fed should go ahead with the next hike as expected.

The governor of the ECB, Mario Draghi, has played the first move and now the markets are waiting to see how his American counterpart, Federal Reserve Chair Janet Yellen, will react. The Fed board has agreed to meet, despite a massive blizzard, which has shut down much of the Eastern United States, to review policy and evaluate the possibility of another rate hike. How wise would that be?

ECB Going Beyond Investors’ Concerns

In Frankfurt, the ECB has used an extremely accommodating tone towards investors, sending them strong signals that it will adopt as many measures as necessary to support the economy in order to achieve higher inflation.

In other words, traders should bet on the ECB both cutting rates further and widening QE through the government bonds buyback program, currently set at 60 billion euros per month. (Source: “ECB’s Mario Draghi Signals Boost to Stimulus Program,” The Wall Street Journal, October 22, 2015.)

ECB Chair Mario Draghi’s tones were the right kind of dovish and intended to set out a roadmap to recovery to counteract the market performance in this first part of 2016, which has penalized European banks. However, if Europe is settled on the growth path, or at least on a path to stimulate growth, the potential obstacle remains the United States. This week, perhaps as early as Tuesday or Wednesday, the Fed will assemble for the first time since lifting the nominal rate at the end of 2015.

Nevertheless, the sentiment is bullish in the sense that this time, few expect an additional rate hike, for which a meeting in March is more likely given the coincidence with an update on macroeconomic estimates. International tensions due to wobbly financial markets, signs of a slowdown in China, the collapse of oil, and the contrast with stable U.S. growth suggest that the Fed will be very cautious in tightening its monetary policy again.

Despite the optimism, investors should remain cautious. It is not time for euphoric point-and-shoot-type investing yet. Volatility remains high and the risks of investing do, too. Oil and China are just two of the uncertain variables. After climbing in pre-market trading, oil prices dropped by some $2.00 and they appear to be heading to a new low. On January 22, they went below $27.00 and if $20.00 seemed to be the ultimate bottom price per barrel—some analysts and industry insiders, like BP’s CEO, are now suggesting $10.00! (Source: “Oil price: recovery predicted – but it’s still ‘one for the brave’,” The Week, January 21, 2016.)

Chinese markets continue to move along a rollercoaster, as investors grow increasingly concerned about the slowdown in the second world economy and its impact on global growth. The Shanghai Stock Exchange closed down 3.23% on January 22.