Depreciation of the euro against the dollar: blessing or danger?

The euro peaked at $1.23 on January 6, 2021, but has logically fallen in value for more than a year. First at $1.17 in March 2021, before rising to 1.22 in May-June, finally falling in value to 1.12 in mid-November and finally collapsing around $1.05 since April 28, 2022. the well-meaning and thus majority economists who insisted only a few months ago that the dollar should permanently collapse against the euro? The most “brave” among them did not hesitate to set targets between 1.20 and 1.30 dollars for one euro. damn! Back then, with our forecast of a euro/dollar inevitably returning to about $1.05 in 2022, we made people laugh. But still…

Far from being proud of this success (we also want to thank the many people who sent us congratulations), we just want to remind you that, like all our predictions, the euro/dollar one did not come true a hat. And rightly so: we set all our expectations solely on the basis of economic and financial fundamentals.

The fall of the euro below $1.10 is thus justified and only confirms the reality of the economic and financial divide between the United States and the eurozone.

The euro falls and stabilizes around $1.05

ECB, ACDEFIA

Before going into the economic causes of this depreciation, it should be remembered that the dollar is structurally stronger than the euro, representing almost 65% of world foreign exchange reserves, compared to about 20% for the euro. In addition, 50% of the world’s commercial transactions are in dollars while the United States accounts for only 11% of world trade.

In addition, the eurozone’s share of global GDP in purchasing power parities has fallen from 22% in 1980 to less than 12% today. At the same time, that of the United States also fell, but from 21% to 16%.

At the same time, Uncle Sam’s growth has been almost consistently higher than that of the eurozone since 1995. And this, including during the Coronavirus crisis, which was more economically devastating in the Economic and Monetary Union (EMU) than in the United States.

Admittedly, in the first quarter of 2022, US GDP fell while that of the eurozone continued to rise. However, given the leading indicators of activity, this is just a hiccup. In addition, it should be noted that US GDP has increased by 88% since 1995, compared to 47% for that of the Eurozone (excluding inflation, of course).

Confirming these differences, it should also be noted that the employment match is also largely in Uncle Sam’s favor, with a harmonized unemployment rate as defined by the International Labor Office of 3.6% across the Atlantic to 6.8% in the EMU.

Finally, in addition to these advantages of the dollar against the euro, the interest rate differentials also favor the dollar. And all the more so as the US Federal Reserve started tightening its monetary policy well before the ECB.

In addition, it has just increased its target percentage from federal funds by 50 basis points, bringing it to 1%. Such a one-off increase had not occurred since May 16, 2000. This doesn’t make us any younger and reminds us that at the time the Fed had taken drastic measures to deflate the internet bubble and its “irrational exuberance,” in the words of President Alan Greenspan.

Today, this monetary tightening is mainly justified by the increase in inflationary pressures, but also by wages on the other side of the Atlantic.

The magnitude of the gap between the actual US inflation rate of 8.5% and the Fed’s target of 2% also shows that the Federal Reserve’s monetary tightening is far from over. A level of 2% to 2.5% of the target percentage of federal funds by next fall even seems very likely.

To the extent that the ECB’s refinancing rate is and will remain far from these levels, the euro/dollar should stabilize at around $1.05, or even lower, on a sustainable basis.

And all the more so as yield differentials on ten-year government bonds remain largely in favor of the dollar: 3% across the Atlantic, against 1% in Germany and 1.5% in France.

10-year Treasury yields: over 3% in the United States and 1.5% in France

ECB, ACDEFIA

In other words, the depreciation of the euro/dollar is both justified and will continue.

In normal times, this depreciation could be seen as good news, especially for economic activity in the eurozone, which so desperately needs it. Indeed, the normal level of the euro/dollar is around 1.10 dollars for one euro. This is based on both purchasing power parity (PPP) and the natural exchange rate, Natrex says. The latter characterizes the equilibrium level of the euro/dollar according to the main economic fundamentals, such as growth, inflation, savings and the balance of trade.

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In this context, the depreciation of the euro to $1.05 should make it possible to support exports, but also improve the competitiveness of domestic products compared to imported products, which will result in more market for the former. Finally, it should also encourage foreign investment in the EMU while reducing capital flight outside the EMU. Thanks to these favorable developments, it has been empirically shown that an annual depreciation of the euro of 10% translates into a growth gain of about 0.5 point of GDP. Which is certainly not huge, but always bearable in the context of the current and especially future economic weakness.

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

In addition, it should not be forgotten that a euro that is too low and a fortiori below a dollar can also damage the credibility of the EMU and create mistrust in it. As a result, the interest rates on the bonds of certain states, of course Greek, Italian, but also French, could rise even higher than today, reactivating the sovereign debt crisis, which could awaken, like a volcano temporarily asleep. and even more devastating than before.

Underlining that if the fall of the euro/dollar could have some beneficial effects on growth in Euroland, the risk will soon be outweighed not only by escalating inflationary tensions, but also by the emergence of a major political crisis within the EMU. It’s sad to write, but the line between heaven and hell is sometimes very thin, especially in Europe.

Marc Touati, economist, president of ACDEFIA

His new book RESET – What New World for Tomorrow? tops the best-selling budget essays since its release on September 2, 2020

Find all his videos on his Youtube Channel† The latest, Inflation and recession in France: what are the risks?

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