On the other side of the equation, the euro hasn't stopped losing ground, especially since May 2014. In a very convincing speech, Mario Draghi noted that, in a low-inflation environment, the strength of the single currency is a "cause for concern". Could the euro depreciate further, or is it now bottoming out? Let's have a look at the factors that affect the most scrutinised exchange rate on the planet.
We will begin with factors that could push the euro up and the dollar down:
The first point – one of two crucial points in our analysis – is that the real yield differential very clearly favours a rise in the euro (see left-hand chart on the first page). This indicator shows that real US yields are falling significantly faster than European ones, but this owes solely to the rise in US inflation. This trend could however be dampened in the near future, either by a drop in prices in the USA or by an offsetting rise in dollar yields.
More broadly, looking at the euro's performance against all other currencies, the real effective exchange rate is 2 standard deviations below its long-term average (see right-hand chart on the first page). This type of situation arises occasionally but should not last long.
- he growth differential becomes less penalising for the euro, since growth in the eurozone tends to accelerate while it slows in the USA (see chart below). The impact of this factor could decline because economic activity in the eurozone is losing steam. Indeed, consumer spending figures point to slowing momentum in the next few quarters.
The recent uptick in commodity prices, including the much talked about oil prices, works in favour of the currencies of producer countries and against the dollar. The contagion effect could therefore weaken the dollar against other currencies, including the euro.
Contrary to popular wisdom, if the UK left the European Union, capital flows toward the eurozone would get a boost, at least in the short term. British Prime Minister David Cameron is actively campaigning to keep his country in the EU, but there is no shortage of Brexit partisans, including within his own party. This means rough going for the pound sterling – but smoother sailing for the euro – until the referendum in the UK on 23 June.
The US political situation is also unstable and will only get more so as the election approaches. The 2016 presidential campaign will fuel volatility on the forex market, driven in part by the fact that the Democratic and Republican camps are both facing a level of internal opposition that is unprecedented in modern times.
Another factor that helps account for short-term volatility is speculative positions, which are showing less euro selling (see chart below). This is a sign that forex traders no longer really expect the euro to drop sharply. The situation is the opposite when it comes to the dollar, where buying is on the decline.
Now for a look at factors that could further push the euro down against the dollar:
- This is the second crucial point of our analysis: money creation by the European Central Bank (ECB) is diluting the value of the euro, just like quantitative easing by the US Federal Reserve (Fed) undercut the dollar from 2009 to 2014 (see charts below).
- A second, oft-overlooked but important factor is the US inflation differential – producer prices are rising faster than consumer prices – which supports the dollar. This means that, with the fall in commodity prices, companies recovered some pricing power and were able to improve margins in some segments (see left-hand chart below).
The third point will interest investors. The widening of the 2-year yield spread makes carry trades more attractive. It is becoming easier for traders to borrow euros in order to invest in dollars and pocket the premium (see right-hand chart above). We should see more of this in the next few quarters. Each time the Fed raises its key interest rates going forward – or if investors merely expect this to happen – the yield spread will tend to push the dollar upward.
Recent turmoil in the financial sector has convinced the markets that the Fed will not raise rates in 2016. But since the Fed kicked off its effort to normalise monetary policy at the end of 2015, it is unlikely to ignore the excellent health of the US economy because of uncertainties in Asia or surplus oil production. The Fed will have to act sooner or later in view of recent jobs data and inflation levels.
Finally, there are a number of factors that, while not explanatory in nature, could also weigh on the euro versus the dollar.
The dollar's rise against the euro in recent years has been rather steep. But there is nothing special about this latest cycle. In fact, it looks surprisingly similar to the two previous ones (see left-hand chart). We would also point out that dollar rallies tend to last for a long time.
- Recently, the dollar climbed less sharply against the euro than against other currencies (see right-hand chart). But the trend could still reassert itself.
In view of our econometric model, which takes into account most of the explanatory factors discussed here, we expect the EUR/USD exchange rate to remain just above parity through the end of the year (see chart below). That said, keep in mind that although the euro's downtrend has not yet ended, it is slowing. The dollar gained 13% on it in 2014 and 10% in 2015. Let's be reasonable for 2016: +5% would largely suffice.
In conclusion, we will summarise our analysis by looking at the problem from the other side. Not expecting the dollar to rise against the euro in the current environment would be tantamount to ignoring the impact of rising US interest rates and simultaneously underestimating the impact of money creation in Europe. As the saying goes: never fight the central banks.