The euro briefly fell to par with the dollar on Tuesday for the first time since 2002 and was back at par on Wednesday as a combination of recession fears, central bank policy and energy prices battered the common currency.
The euro has been gradually trending lower against the dollar since mid-2021, when markets began to anticipate rising inflation and interest rates.
But things really accelerated after the Russian invasion of Ukraine changed the economic outlook for the eurozone.
With higher energy prices, slower growth and runaway inflation, the economy in the common currency area is now facing a slowdown rather than a strong post-pandemic recovery.
The euro reflected this, falling from $1.15 before the start of the war to today’s parity with the dollar.
Meanwhile, the US Federal Reserve has started raising interest rates aggressively, while the European Central Bank (ECB) is taking a more cautious approach.
So demand for dollars has increased in two ways: as a safe haven during a time of widespread economic uncertainty and to enhance returns on dollar-denominated assets.
What drives it?
FX strategists point to a few causes, but the most important of these is the so-called “interest rate differential” – the gap between US interest rates and eurozone interest rates.
For now, the ECB is still keeping interest rates below zero, while the Fed has tightened 1.5 percentage points this year.
ECB President Christine Lagarde has indicated that the bank will rise a quarter point this month and possibly a half point in September.
Still, market participants are not convinced that these measures will be enough to tame inflation without collateral damage to the economy.
Expectations for the end of the rate-hike cycle have been lowered to 1.4 percentage points from 1.9 percentage points, suggesting the ECB may shy away from what is necessary.
This is a sign that attention is shifting from fighting inflation to a potential downturn. Softer economic data in the euro zone point to a slowdown in growth, tying the ECB’s hands somewhat.
Unless the central bank can contain soaring consumer prices or prop up economic growth, the outlook for the euro is bleak.
Who does it concern?
In a low-inflation environment, a weak euro might not be such a big deal. For one, it can boost exports as goods and services become more competitive at euro prices compared to dollar prices.
But with inflation so persistently high — possibly peaking at 10 percent for the euro zone before decelerating in the second half of the year — the strong dollar is a problem for the broader economy.
First of all, energy is priced in dollars, so when Europe buys oil or gas it is effectively importing more inflation. These higher prices will reduce purchasing power, with domino effects on growth and corporate profits.
Other commodities – from commodities like iron and timber to staples like wheat and sugar – are also valued in dollars. All of this contributes to higher prices for businesses and consumers.
Unfortunately, the relative advantages of exporters are not large enough to offset the overall trend, although some individual companies could benefit from the weaker euro.
what can be done
The situation is extremely volatile. The war in Ukraine shows no end soon.
While oil prices have fallen from previous highs, the possibility of an energy crisis in Europe remains this year as Russia manipulates that natural gas supply.
A lot depends on what the ECB does at the end of the month. The promised rate hike of a quarter point will certainly be kept. Whether that will boost the euro is another matter.
There is a chance to surprise everyone with a bigger hike, but nothing from the reliably leaky ECB Governing Council suggests that will happen.
Ms Lagarde’s performance at the press conference – particularly in relation to guidance on future rate moves – could be more crucial. If markets are confident that the ECB will do whatever it takes to control inflation, the euro could rally.
What do the forex experts expect?
Ironically, a shift in market focus away from geopolitical risks to usual economic concerns could help the euro strengthen.
Forex traders know that the dollar tends to peak early in the rate hike cycle. Once the Fed’s big hikes have the desired impact on inflation, markets could reassess the relative value of the two currencies.
If FX markets think the dollar is overvalued at this point, it could lure capital back into euro-denominated assets, thereby increasing the value of the euro.
But for now, dollar strength will be supported by a hawkish Fed and a dovish ECB.
Until that changes, the current situation is likely to continue.
https://www.independent.ie/business/world/explainer-why-has-the-euro-fallen-to-parity-with-the-dollar-and-what-happens-now-41835575.html Explainer: Why did the euro fall to “parity” with the dollar and what is happening now?