The euro’s recent dip below its parity with the US dollar created anxiety regarding Europe’s growth, policy and inflation outcomes. Is the loss of parity in itself an issue or are there other related concerns that we need to take cognizance of?
Euro-dollar parity is a state where the exchange rate between the euro and the US dollar is at 1:1. On 14 July, a dip below this key psychological level happened for the first time in about 20 years, generating a slew of headlines. Should the break below this level worry us? And more importantly, does this warrant a relook at Europe’s growth, inflation or policy outlooks?
Implications For Europe
At first glance, the event has little impact on the outlook for Europe. Indeed, rather than the euro being terribly weak, it is the US dollar that has been steadily gaining strength. In other words, although EUR/USD is now about 11% below its 5-year average, the US dollar is gaining strength against everything, except for real goods and services. To be sure, the relative appreciation of the US dollar increases the cost of US imports, an unwelcome inflationary impulse, but it also improves the relative attractiveness of the European Union’s (EU) exports to the United States (US).
That said the US is only one of the trading partners of the EU. This means, the impact of the euro’s weakness on eurozone growth and inflation is determined more by the euro’s value on a trade-weighted basis against all its trading partners. On such a basis, the euro is only 4.3% below its 5-year average and half this move happened after 27 June (Figure 1).
Figure 1: Trade-Weighted Euro Near its 5-Year Average
Simply put, the euro is not weak enough to have a major impact on Europe’s growth prospects, especially compared with the massive spike in European food and energy prices and the general global inflation in core goods and services.
But Euro’s Depreciation to 0.90-0.95 Matters
This does not mean we should ignore the recent depreciation in euro. Conditions are very challenging, and we see increased risk of the euro falling to the 0.90-0.95 range for two key reasons. The most important is the risk of a near complete shutdown of Russian gas supplies. Russia has already reduced gas supplies by 60% and with no end in sight to the Russia-Ukraine War and related sanctions, further reductions cannot be ruled out.
Secondly, a widening of peripheral credit spreads is a significant risk that revives fears of another EU debt crisis. In this context, the European Central Bank (ECB) announcing the new Transmission Protection Instrument (TPI) to “counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy” assumes significance. Effectively this would be accomplished by the ECB’s purchases of sovereign debt to contain severe, adverse increases in credit spreads. Nevertheless, even as the new policy likely reduces chances of a debt crisis that threatens the existence of the euro as investors feared during the 2011-2012 debt crisis, it still leaves plenty of room for the widening of EU sovereign credit spreads and periods of heightened investor fear.
Together, both these euro centric shocks would likely coincide not only with another 10%+ depreciation of the euro versus the US dollar but also with a broader fall in the trade-weighted value of the currency.
ECB’s Options and Potential Medium-Term Scenarios
The ECB has little power to support the currency in the event of the above-described circumstances. A recession induced by the rationing of gas supplies would be inflationary, and if the ECB were to remain cautious or to ease to support growth, it will lose credibility on inflation and the euro is likely to suffer. On the other hand, if the ECB were to raise rates to fight inflation and support the currency, investors are likely to worry about an even deeper recession, resulting in the euro suffering again.
Intervention to directly buy the euro is an option but is politically sensitive and is unlikely to be effective given the magnitude of the macro shocks. We think it is unlikely that the ECB will intervene even with the euro falling to 0.90. At the current levels, the trade-weighted euro is not weak enough to warrant a discussion on interventions or revising up inflation forecasts. For these reasons we see the euro’s risks to be skewed lower.
But if Russian gas continues to flow at around the current rate and peripheral spreads remain contained – wider to reflect rising economic risks and tightening policy but not surging to panic levels – then the euro is likely to remain in the recent range, likely between 0.98 and 1.04 versus the US dollar. And, if the US Fed reaches peak rates and inflation turns reliably lower, we would expect the euro to recover to 1.08+ or even above 1.10 versus the US dollar.
Longer term, over the next 3-5 years, the outlook is more constructive. Households are flush with excess savings, corporate balance sheets are in decent shape, unemployment is at a record low since the advent of the euro and we are likely to see fiscal support in a recessionary scenario. The eurozone is well positioned to minimize permanent damage from a recession. It may take 2-3 years, but eventually the EU will find replacements for Russian energy and rebuild inventories. This could be quite healthy in terms of long-term stability of supplies.
Meanwhile, investments in areas such as green tech, digitization and semiconductors could help to improve eurozone’s long-run growth outlook. Capital flows may also improve as ECB policy rates stabilize in positive territory and the next economic recovery cycle encourages a round of inflows into Europe’s relatively cheaper equity markets.
We expect all these positive factors to play out in the context of a broader weakening of the US dollar, which is currently near a 30-year high relative to our estimates of its long-run fair value. Once we are through the current series of macro shocks, we see scope for EUR/USD to recover at least back to 1.20 over the next 5 years.
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