Let’s be honest; it doesn’t take a PhD to figure out where the euro to dollar exchange rate might go next. Based on the current situations in the two economies and their central banks’ respective decisions, there is a strong chance that the EUR to USD would head south in 2016.
Allow me to explain.
Bleak Outlook for EUR/USD
It’s no secret that the eurozone economy has been struggling to recover. More recently, the currency union is facing a major threat—deflation.
In the month of February 2016, consumer prices in the eurozone fell by 0.2% on an annual basis. The drop was much sharper than what economists were expecting. (Source: “Inflation in the Euro Area,” Eurostat, last accessed March 14, 2016.)
Deflation would be detrimental to the eurozone’s economic growth, which was already disappointing. You see, when deflationary pressure builds up, households and businesses might want to hold back on their spending in the hope that prices could drop in the future.
In an effort to stimulate the economy and bring inflation back to its two-percent target, the European Central Bank (ECB) is adopting extraordinary measures. Given that the ECB has missed its inflation targets for three consecutive years, it’s about time to do so.
Last week, the ECB made cuts to all three of its main interest rates. Most notably, the interest rate on its depository facility for commercial banks has been lowered from -0.3% to -0.4%. This means that if commercial banks were to deposit their funds at the ECB, they would actually have to pay the central bank. (Source: “ECB Ramps up Stimulus But Disappoints Markets,” The Wall Street Journal, March 11, 2016.)
Moreover, the European Central Bank also expanded its quantitative easing program. It will be making an additional €20.0 billion in bond purchases each month on top of its current €60.0-billion program. Additionally, it will also start buying corporate bonds.
All of this is bad for the EUR-USD exchange rate. Because in the U.S., things are very much the opposite.
Gone are the days of quantitative easing. Instead, the U.S. Federal Reserve has made its first interest rate increase since the Great Recession.
Also, based on the improving conditions in the U.S. economy, the Fed is likely going to raise rates some time later this year. This means that the Fed and the ECB are moving in opposite directions, which is bad news for the euro to dollar exchange rate. (Source: “Fed to Sit Tight on Rates This Week, but Hint at Hikes to Come,” BNN, March 14, 2016; http://www.bnn.ca/News/2016/3/14/Fed-to-sit-tight-on-rates-this-week-but-hint-at-hikes-to-come.aspx.)
There are strong arguments for a Fed rate hike. For instance, the jobs market in the U.S. has been gaining momentum. In February, the U.S. economy added 242,000 jobs, significantly more than the 195,000 additions the markets were expecting. The unemployment rate also held steady at a low 4.9%. (Source: “Employment Situation Summary,” Bureau of Labor Statistics, March 4, 2016; http://www.bls.gov/news.release/empsit.nr0.htm.)
The Bottom Line on the Euro to Dollar Exchange Rate
Of course, the EUR-USD is a major currency pair. And there are many forces behind the euro to dollar exchange rate. But given the fundamentals of these two economies, the euro could see further downside against the mighty greenback.