Why might the euro continue to weaken against the US dollar?

Why might the euro continue to weaken against the US dollar?
Why might the euro continue to weaken against the US dollar?

The euro has shown a weakening trend against the US dollar since the start of the year. The decline can be attributed to divergence in inflation trajectories of the euro area and the US, suggesting a continuation of the euro’s depreciation relative to the dollar.

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The euro, serving as the official currency for 20 members of the European Union, has experienced a notable devaluation against the US dollar, declining approximately 2.2% since the start of 2024.

Despite a recent minor uptick in the euro’s value, the exchange rate between the two currencies, denoted as EUR/USD, has lingered at historically low levels, hovering just below 1.08 as of 14 May.

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This decline in the euro’s strength can be largely attributed to a pronounced discrepancy in monetary policies pursued by the European Central Bank (ECB) and the US Federal Reserve (Fed), resulting in a widened spread of their government bond yields. Looking forward, it appears that the euro may continue to exhibit weakness in the foreseeable future.

Inflation trajectory diverges

Inflation in the euro area has been in a persistent retreat in 2024, with the headline CPI cooling to 2.4% year on year in April from 2.9% in January, the lowest since October 2023. It’s noteworthy to recall that the eurozone experienced a peak in inflation at 10.6% in October 2022, a surge attributed to the sharp escalation in energy prices following Russian aggression against Ukraine.

The ECB has been aggressively raising its policy rates to combat soaring inflation since 2022. In the past consecutive meetings, the central bank has put a halt to further rate hikes.

The ECB notably adopted an increasingly dovish stance during its April policy meeting, indicating that a rate cut in June would be appropriate, especially as inflation trends toward the targeted level of 2%. ECB President Christine Lagarde Lagarde emphasized that the interest rate trajectory in the euro area should not necessarily mirror that of the US, where inflation saw a resurgence this year.

Another economic indicator that might prompt the ECB to initiate a rate cut sooner is the stagnation experienced by the eurozone’s economy in the second half of 2023.

Europe needs support to grow its economy

In the fourth quarter, the gross domestic product (GDP) of the eurozone expanded by a mere 0.1%, narrowly avoiding an economic recession. Major economies, including Germany, France, Italy, and France, all experienced prolonged contractionary periods in their manufacturing activities. Despite signs of a rebound, the continent eagerly needs a more accommodative monetary policy to provide crucial support to its economy.

In contrast to the situation in the euro area, the United States has been grappling with elevated inflation rates this year. The country’s headline Consumer Price Index (CPI) rose to 3.5% in March, up from 3.1% in January.

This week’s upcoming data release is poised to be a crucial barometer, with consensus forecasts suggesting a slight cooling to 3.4% in April. Nevertheless, this figure remains higher than that observed in the euro area. Consequently, the Fed holds a relatively hawkish stance at its policy meetings, reiterating an outlook for “higher-for-longer” rates.

On the other hand, the US has been in a very strong economic recovery since the pandemic, with its GDP growth outpacing that of the eurozone by more than threefold, reaching 3.4% in the final quarter of 2023. Despite a slight softening observed in the first quarter of 2024, the economic momentum remains robust enough to allow the Federal Reserve to maintain higher interest rates for a longer duration compared with its counterpart, the ECB.

A widening spread between government bond yields

The anticipation of the ECB initiating rate cuts ahead of action from the Fed has led to an increase in the bond spreads between the two government debts. This suggests that bond traders anticipate a faster rise in bond prices in the eurozone compared to their counterparts in the US, given the inverse relationship between bond prices and bond yields. Reports from the Financial Times indicate that major financial institutions such as Pimco and JPMorgan Asset Management have all increased their exposure to European government bonds in response to these expectations.

Traditionally, a country’s currency tends to exhibit a positive correlation with its government bond yields. This relationship stems from the fact that higher bond yields typically signal robust economic growth momentum, leading to increased demand for the country’s currency as investors seek to preserve value. This phenomenon has been consistently observed with the US dollar during each rate hike cycle of the Federal Reserve (Fed).

Interest rate differences may encourage the carry trade

Moreover, elevated policy rates also result in higher deposit rates for the currency, fostering a favorable environment for currency carry trades. This strategy entails borrowing from a currency with a lower interest rate to invest in one with a higher rate, with the aim of profiting from the interest rate differential.

Currently, the European Central Bank’s (ECB) overnight deposit rate stands at 4%, while the Federal Reserve’s rate ranges between 5.25% and 5.5%. The considerable spread between interbank borrowing rates encourages investors to hold onto the currency offering the higher rate while selling off the currency with lower rates.

Consequently, this dynamic contributes to the strengthening of the US dollar and the weakening of the euro.

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