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When the US economy collapsed during the 2008 global financial crisis, one euro was worth about 1.6 times the US dollar. Now a combination of Europe’s front line on Russia’s war in Ukraine and the European Central Bank’s reluctance to raise interest rates has pushed it to parity, or a 1:1 ratio to the dollar. It is the first time since 2002, in the early years of the currency, that the euro has fallen to this level.
1. Why is the euro falling?
Europe is suffering most from the war, which has triggered an energy crisis and could potentially lead to a long and deep recession. That puts the ECB in a difficult position — trying to contain inflation and cushion a slowing economy — as it plans to raise borrowing costs for the first time since 2011. At the same time, the US Federal Reserve is raising interest rates much faster than the 19-nation eurozone. This makes US Treasury yields higher than European debt, driving investors into the dollar and away from the euro. Additionally, the greenback is benefiting from its haven status, meaning the euro will continue to slide as the war drags on and the fallout worsens.
2. Why is a weaker currency a problem?
For years, policymakers in many countries have embraced weaker currencies as a way to stimulate economic growth by making their exports more competitive. But now that euro-zone inflation is at its highest level since these records began, its weakness is undesirable as it encourages price gains by making imports more expensive. In June, consumer prices in the euro area rose by 8.6% year-on-year. Some policymakers have highlighted a weaker euro as a risk to the central bank’s aim to bring inflation back to 2% over the medium term, although the ECB is not targeting the exchange rate. However, compared to currencies other than the dollar, the euro appears to be more resilient.
3. Is the 1:1 level important?
Yes. It’s a psychological threshold for the market. The first time the euro fell to parity against the dollar was in December 1999, less than a year after its inception. As now, analysts pointed to a widening spread between German and US bond yields and stronger US growth. It was a dent in the pride of Europeans, who saw the common currency as an important political project and a rival to the dominant dollar. Today, the euro is considered one of the world’s most important currencies for transactions and reserves, although reaching parity is still symbolic. For financial markets, forex traders are anticipating turmoil around the 1-for-1 level as billions of euros in options bets are tied to that big line in the sand.
4. Where is the floor?
It’s difficult to say. Some analysts predicted the common currency could fall to 90 US cents if Russia escalates the crisis by holding back more gas supplies to Europe. Since early July, options traders have placed more bets around the $0.95 level, with $0.9850 potentially acting as a near-term bottom, according to trade data from the Depository Trust & Clearing Corporation. Strategists at Deutsche Bank have calculated that a slide to $0.95 to $0.97 would match the most extreme exchange rates at any time since the end of the so-called Bretton Woods system in 1971, which linked the value of many currencies to the US -dollar paired. Still, those levels could well be reached if a recession hits, they said.
5. What could trigger a turning point?
The key is to narrow the interest rate differential to other global bond markets. With the Fed raising interest rates by 150 basis points in just three months, the ECB had yet to act and keep interest rates in negative territory. While Europe’s rate setters have signaled the start of their rate hike cycle – including a possible 50 basis point hike in September – doubts are brewing about how long they can sustain it. Rate hikes are more difficult for the ECB than for other central banks. That’s because the borrowing costs of the more indebted eurozone countries risk spiraling out of control as investors begin to question their ability to bear their debt burden. Even the suggestion that policymakers planned to tighten policy in June faster than some expected pushed the Italian 10-year bond yield above 4% for the first time since 2014. Since then, investors have been more or less reassured by promises of a new tool to prevent unwarranted spikes in bond yields. But if that plan disappoints markets, they may start to doubt how much tightening the ECB has to offer.
Read more: Why the ECB needs new tools for bond “fragmentation”: QuickTake
6. Is this an existential crisis for the euro?
No, although aside from value pressures, the single currency has faced challenges as a concept in the past. Since its inception, naysayers have pointed out the difficulties in managing a monetary union of disparate economies. This was most evident during the eurozone sovereign debt crisis of 2012, when investors began avoiding the assets of more indebted countries such as Greece, Italy and Spain. The rise of Eurosceptic politicians in Italy and elsewhere has also raised concerns about the resilience of the bloc. A pivotal moment came in July 2012, when ECB President Mario Draghi pledged to do “whatever it takes” to save the common currency. Still, direct intervention to support the euro in foreign exchange markets is rare, despite central bank action in 2000.
7. Who will benefit from a weaker euro?
More broadly, the euro’s weakness against the dollar is helping European exporters by making their products more competitive and boosting their profits. The Americas account for more than 40% of the sales of 70 major European companies, including Sanofi and Aegon NV. It’s also a relief for US travelers to Europe, reducing travel costs and helping Americans at home fight their own imported inflation.
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