Euro Against Dollar
After a significant depreciation against the dollar in 2022, the euro has rebounded strongly. Key drivers include the reversal of the Eurozone’s current account balance from deficit back to surplus and the narrowing of the 1-year interest rate differential with the US since autumn 2022. This reflects market anticipation that the Federal Reserve is nearing the end of its tightening cycle while the European Central Bank (ECB) still has further rate hikes to implement. This interest rate differential is expected to remain a primary driver of the euro-dollar exchange rate in the coming months. Furthermore, the probability of the Federal Reserve cutting rates before the ECB is increasing. Significant unhedged dollar positions held by international investors could exacerbate dollar depreciation, as they may be compelled to reduce their dollar exposure by selling dollar-denominated assets. Finally, the euro remains significantly undervalued compared to its long-term fair value against the dollar.
The euro’s substantial depreciation in 2022, particularly when it fell below parity with the dollar in August, raised concerns. This depreciation, largely attributed to the divergence in monetary policy between the US and the Eurozone, created inflationary pressures for the euro area, primarily through increased costs of energy imports priced in US dollars. Furthermore, the typical benefits of a weaker currency, such as improved competitiveness and growth support, were hampered by global supply chain constraints and logistical bottlenecks.
The euro’s recent appreciation should alleviate inflationary pressures by impacting import prices, assisting the ECB in its fight against inflation. Economic models suggest a 10% appreciation of the euro’s effective exchange rate could reduce inflation by 0.7 percentage points after a year.
Several factors contribute to the euro’s renewed strength. The Eurozone’s current account balance, which has shown a strong correlation with the euro-dollar exchange rate since 2020, is a key factor. After falling into deficit in the spring of 2022, primarily due to a surge in energy import costs, the current account has returned to a surplus. A current account surplus can support the currency and/or exert downward pressure on bond yields.
A widely held belief is that rising bond yields in one country relative to another should attract international capital, leading to an appreciation of the former’s currency. However, the relationship between bond yield differentials and exchange rates is more nuanced. Investor preferences and differing risk characteristics can influence this relationship. The correlation between the euro-dollar exchange rate and the difference between 10-year German Bund yields and 10-year US Treasury yields has been low historically, demonstrating the complex interplay of factors beyond simple yield differentials.
The 1-year interest rate, largely reflecting market expectations of future central bank decisions, offers a better gauge of monetary policy divergence. A strong correlation exists between the 1-year interest rate differential between the US and the Eurozone and the euro-dollar exchange rate since late 2021. Initially, the Federal Reserve’s more hawkish stance, reflected in a widening 1-year interest rate differential, supported dollar appreciation. However, the narrowing of this differential since autumn 2022, indicating that the Federal Reserve is approaching the end of its tightening cycle while the ECB has more to do, has bolstered the euro.
Two additional factors support further euro appreciation. Large unhedged dollar positions held by international investors could trigger further dollar selling if the dollar continues to depreciate. Moreover, the euro remains considerably undervalued against the dollar compared to its estimated long-term fair value, potentially attracting investment, especially when cyclical conditions, such as the monetary policy outlook, align with this undervaluation.