What could come after parity?
The forex market is dominating the headlines at the moment. EUR/USD has fallen more than 6% since the start of this month and is nearly 25% lower since peaking at 1.40 in May last year. The pace of the decline has been stunning: since the last Non-farm payrolls report on March 6 alone, EUR/USD has fallen nearly 400 pips.
What is driving the EUR lower?
Central Banks: The Federal Reserve and the European Central Bank have been taken opposite monetary policy stances in recent months, with the ECB embarking on quantitative easing while the Federal Reserve is contemplating a rate rise later this year. This divergence has driven the yield spread between German and U.S. 10-year bond yields to a 26-year low. Since yields can determine a currency’s strength, record low European yields is a major factor driving the EUR lower.
The Dollar: It’s not just the EUR that has been hammered by the buck; the USD has outperformed all but one (CHF) of its G10 peers this year and has also made large gains against some emerging market currencies, including the Brazilian real, Turkish lira and Czech Koruna. Some believe that we are at the start of a major dollar uptrend.
Economic and Sovereign Concerns: The currency bloc is still suffering from the effects of the sovereign debt crisis. Some Eurozone countries are still burdened with debt and growth is not yet strong enough to alleviate this situation. Greek default risk remains high and will come back into focus in June when its bailout is due to expire.
Overall, we think that the bigger risk in the short term is for more EUR weakness. A break to parity in EUR/USD, the lowest level since September 2002, and potential further declines could equate to a move to around 110.00 in the dollar index. This could have major implications for broader financial markets in the coming months including the following:
- A further sell off in emerging market FX, particularly currencies with large USD-based external debts like Turkey,
- A drop in US equity indices as corporations see their overseas profits hit by the strong buck,
- A boost for European equities, which tend to rally when the EUR sells off, and
- A boost to growth in the currency bloc as the economy gets a double whammy from a weaker currency and a lower oil price.