EUR/USD Exchange Rate Could Plunge in 2016
The euro to dollar exchange rate has shown weakness in 2015, setting the stage for deeper losses in the EUR/USD. As we head into 2016, Europe is struggling to starve off economic collapse, while the dollar is catching a bit of a tailwind.
America’s central bank, the almighty Federal Reserve, is gearing up for an interest rate hike in December, creating a strange environment for the EUR/USD. The U.S. economy is finally performing well enough for the Federal Reserve to step back and let go, but Europe’s economy is not.
Mario Draghi, the head of the European Central Bank, recently hinted that interest rates will remain low for the near future. (Source: “ECB ponders options as it looks to inject fresh economic stimulus,” CNBC, November 29, 2015.) His coded language basically translates to, “Sorry, the economy isn’t strong enough to stand on its own two legs yet.”
This disparity between the U.S. and Europe tells us a lot about where the euro to dollar exchange rate is headed. After all, we’ve been living in extraordinary times and the normal rules of economics don’t apply; almost everything is counterintuitive.
Why has the EUR/USD exchange rate fallen by 12.7% since the start of 2015? And how much further can it fall? The answers to those questions lie directly in the Federal Reserve’s actions this month. Let me explain…
The Euro to Dollar Outlook 2016
There are two reasons why the EUR/USD relationship could collapse in 2016.
First off, a limitless money supply and rock-bottom interest rates saved the U.S. dollar. Cutting interest rates was supposed to promote lending (and spending) in the economy, while the money supply was used to purchase toxic assets from troubled banks.
While that worked at the start of quantitative easing, it’s doesn’t anymore. Just take a look at the total loans made to businesses this year.
For the latter half of 2014, most investors believed the Fed would raise rates in the following year. Then came a dip in sales and consumer sentiment, forcing a resurgence of pessimism. It looked like the central bankers would kick the can down the road.
And when it looked like no rate hike was coming, lending to businesses shrank. How does that make sense? If low interest rates make it cheap to borrow cash, why would banks react negatively to the absence of a rate hike?
I think it’s because we became comfortable with low interest rates. There was no urgency to lend because no one really believed that a rate hike was coming. However, now we have a credible threat of higher interest rates on the table and everyone is lining up for a loan.
These aren’t the type of bad loans that crushed the U.S. economy in 2008. Business loans are used by companies looking to expand and grow. That’s the kind of capitalism that will keep the U.S. dollar strong for the next few years.
Things look much worse across the pond. Europe was slow to react to the financial crisis, opting for weak, half-measures instead of decisive actions. The continent’s deep-rooted fears of inflation kept the European Central Bank (ECB) averse to Fed-like stimulus.
Then there were the (multiple) Greek tragedies that wreaked havoc on financial markets. Europe seemed to be coming apart at the seams. To pacify uneasy investors, Mario Draghi promised a little more stimulus and so the day of judgment was pushed back. (Source: “ECB ponders options as it looks to inject fresh economic stimulus,” CNBC, November 29, 2015.)
Now the euro’s ultimate test is coming. The Federal Reserve is about to raise interest rates and markets will likely have momentary jitters before calming down. That’s when the truth becomes obvious. The U.S. economy will be free of all support, growing on its own merits, and Europe will be stagnating.
The Bottom Line on the EUR/USD Outlook
Simply put, one country recovered and the other did not. Currency speculators could flee the euro, driving up the relative value of the dollar. It’s not a very hopeful prediction, but all the evidence points to a coming storm for Europe. I’m going to make sure my money is as far away as possible.