Does the EUR to USD Exchange Rate Have More Downside in 2016?
The eurozone’s economic woes seem to be eternalizing. The European Central Bank (ECB) is no longer hawkish. An interest rate cut is almost certain now, bearing a bad omen for the euro to dollar exchange rate in 2016.
The dilemma facing the ECB’s Mario Draghi is whether to cut now or wait another quarter. Either way, the EUR to USD exchange rate has one way to go and that’s south.
At the ECB’s policy meeting last week, ECB President Mario Draghi indicated that the central bank is now looking at two signs. Either of the two, if missing, could force the bank to go for further cuts in its lending rate.
The first of these signs is a response from the economy in the form of inflation. The second sign is a response from the financial sector in the form of higher lending and spending. Draghi categorically stated that he will “not hesitate to act” if the economy doesn’t show signs of improvement in these indicators.
I have reason to believe that Draghi will act; meaning that another round of quantitative easing might be on its way, which could put further downward pressure on the EUR/USD exchange rate.
Allow me to explain…
Tumbling energy prices are keeping inflation expectations low. So far, we have not received any solid bullish signals on oil prices. On and off, we hear rumors of output cuts, which momentarily send oil prices higher. But come the next day, another rout kicks in.
Inflation in the eurozone is currently hovering around 0.2%. To be fair, that number doesn’t deserve to be called inflation. Correctly put, the region is struggling with deflation. A lack of economic activity is keeping investors at bay. Meanwhile, consumer spending is bottoming. As a result, corporate profits are being squeezed and so is the region’s economic output.
The only way out is for the economy to receive a well-deserved stimulus. The way Draghi sees it, this stimulus needs to be monetary and it needs to follow an interest rate cut.
As for the second indicator, the financial sector is more troubled than ever because of fears of an upcoming negative interest rate policy (NIRP). Low interest rates are already causing a dent in the profits of eurozone’s financial institutions. Negative interest rates will further threaten their survival. Take, for instance, Deutsche Bank, which is facing bankruptcy risks now.
But Draghi could care less. He believes that it’s only the overly leveraged banks that will land in trouble in the event of an NIRP. Better-managed banks will not only survive, but they will also help save the economy by boosting spending and lending. He may be right, albeit only partly.
Negative interest rates would mean that the banks will have to charge depositors for keeping their money in the bank. This will force depositors to withdraw the money and spend it. Likewise, borrowers will be paid interest for borrowing, thus boosting borrowing and, ultimately, spending. On paper, it seems easy as pie. Practically, however, the results may not be on target.
The flip side of the coin is that this can cause a bank run. Europeans might withdraw all their money from banks to stash it under their mattresses in cash.
The ECB’s strategy may also backfire if banks respond with a counter policy. If all of these banks face survival threats on the back of reduced profits, they may join hands to counter the ECB’s efforts by charging fees on loans or charging premiums on deposits.
The Bottom Line on the Euro
Nonetheless, the ECB has run out of options. March, June, or September—a rate cut is coming. It’s no longer a matter of if, but when.
Simply put, this signals more downside for the EUR/USD exchange rate in 2016.