The euro is close to parity against the dollar for the first time in 20 years, compared with around $1.22 in June last year and far from $1.60 when the United States entered the crisis. In fact, we have seen how the EUR/USD cross falls and rebounds from new cycle lows around $1.0070 on Friday.
The dollar strengthened on risk aversion sentiment because concerns about Russia’s war in Ukraine, rising inflation, supply chain issues, slowing growth and tightening monetary policy led investors to turn to traditional safe-haven assets and the dollar is well positioned.
And it is that to date there is considerable divergence between the Fed and the ECB. Fed Chairman Jerome Powell said the central bank will not stop raising rates until inflation falls to a manageable level. He reiterated his goal of bringing inflation closer to the 2% target set by the Fed. However, the European Central Bank has not raised interest rates, despite the high rate of inflation in the EU.
If the Fed raises rates and the ECB does not, there is a clear incentive to be in dollars, since the profitability of the US treasury bonds are higher than those of the European debt.
The key is the monetary policy to follow… We start from a Federal Reserve that has increased its interest rates by 150 basis points, while the ECB did not move. While Europe’s rate setters have signaled the start of their rate hike cycle, including a potential increase of 50 basis points in September.
Staying behind has its consequences when assessing the strength of both currencies which will imply a direct impact on their respective imports and exports. The weakness of the euro poses a threat to price stability in the Eurozone by making imported goods and raw materials more expensive, thanks to the higher cost of dollars.
We are already in high inflation rates and in the coming months everything will depend on the actions undertaken by the monetary authority.
If we let the euro fall, we will be importing a higher degree of inflation because Commodities that have already suffered a strong appreciation are quoted in dollars. More inflation means depressed real wages, a complex investment environment because your real returns will be negative in most categories of the investment universe, and a constant source of uncertainty that makes long-term planning difficult.
In a net energy importing environment such as Europe, dependency and a weakened currency is a problem. It is clearly seen in gas prices. Natural gas prices in Europe have risen sharply overall and they show a strong oscillation in recent months, a reality that is not replicated in the same way in the United States with lower prices and softer oscillations.
Likewise, a rise in oil prices (due to price and currency effect) entails a transfer of income to the rest of the world and, therefore, impoverishment. If wages do not immediately adjust to rising prices, purchasing power and consequently consumption will decline in the short run. Companies, for their part, cannot immediately pass on the increase in energy prices in their sales prices, so their margins are reduced, to the detriment of investment. When companies raise their prices, they retain their margins but lose market share.
So should the ECB raise interest rates? A prioriit may be the lesser evil to have a stable currency, but this step is more complex than it may seem because the borrowing costs of the most indebted nations of the eurozone are at risk of getting out of control if investors begin to question its ability to sustain the debt burden. Spain has a debt to GDP ratio of 118% and in the serious debt crisis it was close to 70%.
Even the simple hint by policymakers that they planned to tighten policy faster than some expected in June made the Italian 10-year bond yield rose above 4% for the first time since 2014.
Since then, investors have been more or less reassured by promises of a new tool to avoid unwarranted spikes in bond yields, through purchases as the debt purchased by the ECB matures. However, if that plan disappoints markets, they may start to doubt how much the ECB will tighten.