The decline of the euro against the dollar: blessing or danger?

While it peaked at $1.23 on January 6, 2021, the euro has logically fallen for more than a year. First at $1.17 in March 2021, before rising to 1.22 in May and June, then finally declining towards 1.12 in mid-November and finally collapsing around $1.05 since April 28, 2022. Where are the well-meaning economists and therefore the majority of economists, a few months ago Has he stubbornly asserted that the dollar should permanently collapse against the euro? The most “courageous” among them did not hesitate to set targets between 1.20 and 1.30 dollars per euro. Curse! At the time, with our predictions that EUR/USD would inevitably return to around $1.05 through 2022, we made people smile. However…

Far from being proud of this success (we would also like to thank the many people who sent us congratulatory messages), we would simply like to remember that, like all our predictions, the EUR/USD never came out of a hat. And for good reason: We base all our forecasts solely on economic and financial fundamentals.

Thus, the drop in the Euro below $1.10 is justified and only confirms the reality of the economic and financial gaps between the US and the Eurozone.

Euro falls and settles around $1.05

European Central Bank, ACDEFI

Before detailing the economic reasons for this currency devaluation, let us remember that the dollar is structurally stronger than the euro, as it accounts for approximately 65% ​​of global foreign exchange reserves, versus about 20% for the euro. In addition, 50% of the world’s trade transactions are conducted in dollars, while the United States accounts for only 11% of global trade.

In addition, the eurozone’s share of global GDP at purchasing power parity has fallen from 22% in 1980 to less than 12% now. At the same time, the growth rate in the United States also decreased, but from 21% to 16%.

At the same time, since 1995, Uncle Sam’s growth has been almost constantly higher than that of the eurozone. And this, including during the coronavirus crisis, which has been more economically devastating in the EMU than in the United States.

Admittedly, in the first quarter of 2022, US GDP declined while the Eurozone continued to advance. However, given the main indicators of activity, this is nothing but a hiccup. Moreover, it is worth noting that since 1995, the US GDP has increased by 88%, compared to 47% for the eurozone (obviously excluding inflation).

Emphasizing these differences, it is also worth noting that the employment match is also largely in favor of Uncle Sam, with a harmonized unemployment rate as set by the International Labor Office at 3.6% across the Atlantic versus 6.8% in the EMU.

Finally, to complement these advantages that the dollar has against the euro, the interest rate differentials are also in favor of the dollar. More importantly, the US Federal Reserve began tightening its monetary policy long before the European Central Bank.

Furthermore, she had just increased her target rate Federal or state funding by 50 basis points, to 1%. Such a one-time rise has not occurred since May 16, 2000. It does not make us younger and reminds us that at a time when the Federal Reserve used drastic measures to deflate the Internet bubble and “irrational exuberance”, in the words of President Alan Greenspan.

Today, this monetary tightening is justified mainly by increased inflationary pressures, but also in wages across the Atlantic.

The size of the gap between US actual inflation of 8.5% and the Fed’s 2% target also shows that the Fed’s monetary tightening is not over yet. Level 2% to 2.5% of the target rate Federal or state funding By next fall it seems very likely.

As far as the ECB’s refinancing rate is and will remain far from these levels, the EUR/USD should permanently settle around $1.05, or even lower.

More importantly, interest rate differentials on 10-year government bonds are still largely in favor of the dollar: 3% across the Atlantic, versus 1% in Germany and 1.5% in France.

10-year government bond rates: above 3% in the US and 1.5% in France

European Central Bank, ACDEFI

In other words, the decline of the EUR/USD is justified and set to continue.

In normal times, this drop can be seen as good news, especially for much-needed Eurozone economic activity. In fact, the normal level for EUR/USD is around $1.10 per euro. Natrix says this depends on both purchasing power parity (PPP) and the natural exchange rate. The latter characterizes the equilibrium level of the euro / dollar according to the main economic fundamentals, such as growth, inflation, savings and trade balance.

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In this context, the depreciation of the euro to 1.05 dollars would make it possible to support exports, but also to improve the competitiveness of national products against imported ones, which would lead to more market for the former. Finally, it should also encourage foreign investment in the EMU while reducing capital flight out of the latter. Thanks to these positive developments, it has been empirically proven that the annual depreciation of the euro by 10% translates into a growth increase of about 0.5 points of GDP. And it’s certainly not huge, but in the context of the current economic weakness and especially in the future, it’s always a good idea to take it.

On the other hand, given the current high inflation, these advantages are likely to melt like snow in the sun. In fact, the depreciation of the euro is also reflected, above all, in an increase in imported inflationary pressures. However, more inflation means less purchasing power, and therefore less consumption and growth, which will weaken the Euro again.

Moreover, we should not forget that a very low euro and a fortiori less than the dollar can also damage the credibility of the European Monetary Union and provoke a movement of mistrust towards it. Thus, interest rates on the bonds of certain countries, Greek, Italian and, of course, French, could rise even higher than they are today, revitalizing the public debt crisis, which could wake up and become, like a volcano temporarily dormant. More devastating than before.

What confirms that if the decline of the euro/dollar can have some beneficial effects on the growth of the euro area, these risks quickly fade not only through the increase in inflationary tensions, but also through the emergence of a major political crisis within the European Monetary Union. It’s sad to write, but the border between heaven and hell is sometimes very thin, especially in Europe.

Marc Touati, Economist, President of ACDEFI

His new book RESET – What new world for tomorrow? Budget articles have topped the list of bestsellers since its release on September 2, 2020

Find all his videos on his site YouTube channel. Most recently, inflation and stagnation in France: What are the risks?

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