Bad News for Euro to U.S. Dollar Exchange Rate
After Mario Draghi, president of the European Central Bank (ECB), ruled out further increases in interest rates, the EUR/USD pair lost some of the ground it gained last Friday. The euro to U.S. dollar exchange rate has now settled around 1.1114. And the ECB and its American equivalent, the Federal Reserve, have shown the markets in which direction they intend to shift their currencies.
For several years, the Fed, in an effort to boost liquidity, pushed interest rates toward zero. In that sense, both the ECB and the Fed have been trying to stave off recessions. The measures have largely worked. Unemployment rates have fallen, generally, and stock exchanges have moved upward. Therefore, the ECB and Fed have moved in predictable patterns.
This is going to continue. On Wednesday, the Fed will take some of the limelight away from the ECB after a two-day policy meeting. While Fed Chair Janet Yellen did promise more than one rate hike last December, the institution will continue to stay on the sidelines; it will not raise rates. Although the U.S. economy continues to expand, growth has been softer in 2016 compared to the pace of growth in the second half of 2015.
Indeed, while the Fed was printing U.S. dollars like there was no tomorrow in 2014, it slowed the pace of printing in the last weeks of 2015. Yet it did so in such a way as to avoid disrupting the markets, limiting the increase by a meager 0.25%. The result is that the euro could soon reach parity with the dollar. However, the speed at which this may happen has not matched expectations.
Indeed, the ECB’s latest round of incentives, or stimulus measures, has not translated into a sufficient drop in value for the euro to prompt parity yet. Despite the euro’s fall against the dollar in the second week of March, the euro was still trading around the $1.10 threshold. Nevertheless, should Fed Chair Yellen hint at a possible rate hike later in the year—as she suggested last December—the euro to U.S. dollar exchange rate could start to move higher.
Meanwhile, in February 2016, consumer prices in the eurozone dropped 0.2% on an annual basis—deeper than expectations. (Source: “Inflation in the Euro Area,” Eurostat, March 15, 2016.) Draghi and the ECB need to continue stimulating economic growth in the eurozone. Left to its own devices, the European economy still lacks the strength to grow.
It is unlikely that European growth or inflation will reach a high enough level to warrant a shift in the short term. Therefore, even if it may take a little longer, EUR/USD parity is a realistic expectation. The euro and the EU economy are also under geopolitical pressure. The refugee crisis is fueling instability and reactionary policies.
The German interim municipal elections have seen right-wing (anti-immigrant/refugee) parties get the lion’s share of votes. This is important. Germany is Europe’s largest economy and Chancellor Angela Merkel has suffered a major political blow. She says that the openness policy will continue, but she will face increasing popular and political resistance. This adds a new source of instability. It will contribute to a weakening of the euro. (Source: “German State Elections Point to Vulnerability for Angela Merkel,” The New York Times, March 14, 2016)
In contrast, the U.S. labor market created 242,000 jobs in February, according to the U.S. Labor Department. Meanwhile, the unemployment rate remained at 4.9%, its lowest level in eight years.
The Fed has the argument it needs to raise interest rates. This may not happen on March 16, but it could happen by the summer. At that point, given the weather patterns, the refugee problem will become larger and, in the current European context, put bearish pressure on the euro to dollar exchange rate.
That’s when the chance of U.S. dollar-euro parity will be highest.