Euro to Dollar Crash Coming Despite Widespread Bullishness

Euro to Dollar CrashEUR to USD Parity in 2016 a Possibility

This past December could be remembered as the turning point in the euro to dollar exchange rate. Since hindsight looks on the past from a shallow angle, blurring events into a narrative, history could remember this month as the start of a spectacular crash in the EUR to USD.

My point is the individual meetings of the European Central Bank (ECB) or the Federal Reserve will matter less than their cumulative effect on the world economy. Most of the financial press concern themselves with the immediate fallout of such meetings, but those consequences are always short lived.

Figuring out the one-year forecast of the euro to dollar exchange rate is a little more difficult. The global economy has hundreds of moving parts and making good predictions means estimating how those factors will interact across markets.

That’s why analysts end up with multiple scenarios for how a situation can evolve. It’s more about probability than anything else. However, we’re in a weird situation with the EUR/USD, where it seems like all roads lead to the same conclusion.

Let me explain…

Powerful Forces Want a Drop in Euro

So let’s try and put recent history into chronological order. At first, the euro began to drop in the weeks before a key meeting of the European Central Bank. Investors were expecting the ECB to back up a Brinks truck into financial markets and dump a whole lot of monetary stimulus out there. They pre-emptively lowered the EUR to USD.

However, the stimulus package was smaller than expected, forcing the euro to edge higher. Investors were clearly too optimistic about the ECB’s willingness to intervene in the markets, even though Mario Draghi insists he will do anything to save the eurozone. (Source: “Fed Rate Rise Raises Questions Over ECB Policy on Euro,” Wall Street Journal, December 17, 2015.)

The ECB President has continuously argued that a lower EUR to USD exchange rate could help revive the European economy. And yet he’s shied away from doing it himself.

If the ECB was willing to back up its words, the stimulus package would have met expectations. At the time, I wrote that perhaps Draghi was counting on a rate hike from the Federal Reserve to make European exports more attractive by comparison.

If so, he severely miscalculated. The Fed did raise interest rates, but the euro to dollar exchange rate didn’t move all that much. My guess is that investors are holding out for the stimulus plan they wanted before they move on the euro.

That may sound a little extreme, but you’d be amazed at how much of monetary policy depends on effective communication. Even the idea of lowering interest rates is meant to induce spending in the economy. But people won’t borrow to spend unless they are convinced that rates won’t drop any further. They’d choose to wait instead.

EUR to USD Exchange Rate Outlook

So it looks like Mario Draghi’s attempt to leverage a U.S. rate hike didn’t work out. The euro didn’t drop far enough for there to be much difference in the underlying European economy, which leaves the ECB in an uncomfortable position.

They can either continue pumping in 60 billion euro a month, while not achieving very much, or increase that amount slightly and get the results they need. Or they could even slash the interest rate from its current level of 0.5%—it’s simply a matter of tradeoffs. (Source: “Exclusive: ECB lowered stimulus ambitions after hitting opposition – sources,” Reuters, December 5, 2015.)

Consider also that both Japan and China have stepped up their central bank purchases after the Federal Reserve raised interest rates. There’s an obvious opportunity to undercut your own currency as a means of boosting exports, which convinces me that the ECB will eventually cave to pressure.

All told, I’m staying far away from the euro for the next year.

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