The return of the US Dollar

Financial Article 13 by Christopher Mallia - May 31, 2018

The US Dollar and the euro are the two most traded currencies in the world reflecting the leading economic position of these two regions across the globe. In the past decade, the euro / US Dollar (EUR vs USD) exchange rate has experienced significant swings largely reflecting the crises faced by both regions and the responses from the relevant authorities as well as political developments on both sides of the Atlantic.

Since currencies are priced against one another, the performance of a currency signifies relative strength or weakness against another currency. In this article, the convention being used to quote the EUR vs USD exchange rate signifies the amount of US Dollar required to purchase one unit of euro. Hence, a higher absolute value refers to a weaker US Dollar or stronger euro and vice-versa.

Prior to the 2007/8 global financial crises, euro strength was evident with an exchange rate of USD1.60. However, the US Dollar gradually gained ground as the swifter and more expedient response to the financial crises by the US Federal Reserve compared to its European counterpart, enabled the North American economy to emerge from recession in a shorter time-frame. In fact, by the end of 2008, the US Federal Reserve had reduced its benchmark interest rate to a range of 0% to 0.25% from 5.25%. Apart from a significant reduction in the interest rate in just 16 months, the US Federal Reserve also embarked on an extraordinary asset purchase programme as it grew its balance sheet by around USD3.5 trillion over seven years.

This aggressive monetary policy expansion led the US Federal Reserve, in September 2014 to outline a plan of monetary policy normalisation whilst the European Central Bank (ECB) was still cutting its benchmark rate as the region was also seeking to counteract the adverse effects of the sovereign debt crisis across the eurozone. As a result, the exchange rate fell to USD1.36 and as the US Federal Reserve actioned its monetary policy tightening with a rate hike in each of 2015 and 2016 (whilst the ECB maintained an accommodative stance), the EUR vs USD exchange rate approached parity as it hit the USD1.035 level – the lowest level in 14 years.

On the other hand, as the US Federal Reserve accelerated its monetary policy tightening in 2017 (comprising three rate hikes of 25 basis points each), the US Dollar unexpectedly started to weaken against the euro and the exchange rate trended higher towards the USD1.10 level. This turnaround was likely triggered by the uncertainty surrounding the policies (including budget deficits, tax cut plans and protectionism measures) of the then newly-elected US President Donald J. Trump as well as the surprise €20 billion a month reduction in the monthly asset purchases of the ECB in late 2016 which overshadowed the fact that the ECB actually expanded its stimulus programme further into the future. In September 2017, the ECB then announced a further reduction in its monthly asset purchases with effect from January 2018 to €30 billion. These actions, coupled with a wave of upbeat economic data from the eurozone, fuelled speculation that the ECB was moving closer to its first rate hike since 2011. As a result, the EUR vs USD exchange rate reached USD1.2555 in mid-February 2018 – the highest level since mid-December 2014.

Nonetheless, in yet another turn of events, the EUR vs USD exchange rate subsequently started easing as the US Dollar strengthened in line with the incongruent pace of the economies within the respective regions. In fact, prospects of a rate hike in Europe were being pushed forward further into 2019 on the back of a string of disappointing data including lacklustre inflation readings. In this respect, the ECB’s latest economic forecasts published in March 2018 revealed a lower estimate for inflation in 2019 (1.4% compared to the previous forecast of 1.5%) and also show that the region’s inflation rate is not expected to come close to the ECB’s target of just below 2% until 2020. The latter is also confirmed by forecasts published by the European Commission, the Organisation for Economic Co-operation and Development (OECD) and the International Monetary Fund (IMF) amongst others. Furthermore, the ECB projections also indicate that in 2019 and 2020, real gross domestic product (GDP) growth is projected to slow as the impact of past monetary policy measures should dwindle going forward.

In contrast, the economic momentum in the US is expected to remain supported as the latest projections by the US Federal Reserve (also published in March 2018), indicate an inflation rate of 1.9% for the US in 2018 (as opposed to 1.4% for the eurozone) and is expected to reach 2% in 2019 and 2.1% in 2020. Additionally, the unemployment rate in the US of 3.9% is already significantly below that of the eurozone at 8.5% and is expected to reach 3.6% in 2019 whilst the ECB anticipates an unemployment rate of 7.7% next year. This economic progress should enable the US Federal Reserve to continue pursuing its monetary policy normalisation plans which anticipate that the federal funds rate should exceed the 3% level by the end of 2020 (compared to the current range of 1.5% to 1.75%). In contrast, the ECB does not provide any official forward guidance on its benchmark interest rate and its governors have been sending out vague and mixed signals on when the central bank will be considering actioning a rate hike.

Apart from economic considerations, the exchange rate is also heavily influenced by developments in the political sphere. Again, the eurozone is facing greater challenges in this respect than its counterpart across the Atlantic. Currently, the Five Star Movement and the Northern League in Italy, two parties which gained most votes in the recent general elections, are forming a government. Their populist and Eurosceptic views have created a lot of uncertainty and more importantly have once again highlighted the fragmented nature of the political scenario in Europe.

Meanwhile, in the US, the political model is more unified. Furthermore, although the current President is unpredictable, the US has made political strides under Mr Trump’s leadership including the recent agreement with China whereby the Asian country has committed itself to increase its purchases of US goods whilst the US will suspend the planned imposition of trade tariffs which had raised fears of a trade war between the two largest economies in the world.

These latest developments have led to an increased demand for the ‘safe-haven’ US Dollar with the EUR vs USD exchange rate dropping to a new 6-month low of USD1.1715. The significant differences between the two regions both from an economic perspective as well as from the political sphere, are reflected in the respective bond yields. In this respect, it is important to highlight that the spread on the 2-year yield (namely the difference between the yield on a 2-year US Treasury and the German Bund) has reached its highest levels in almost 30 years.

Although volatility is likely to persist going forward from one week to the next as currency markets are influenced by wide-ranging factors, prevailing conditions indicate support for a stronger US Dollar. Meanwhile, although the structural issues in European politics could very possibly derail or slowdown the economic progress achieved so far, other factors, such as the recent surge in the price of oil to USD80 per barrel for the first time since late 2014, could impinge on this latest bout of strength of the US Dollar.    In fact, it is worth noting that analysts are not in agreement over the path of the EUR vs USD exchange rate. This is reflected in recent publications by some major research houses with one bank forecasting the EUR vs USD at the USD1.15 level by the end of 2018 while another bank predicts a scenario with a stronger euro at the USD1.28 level.

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