Parity to dollar shows fear of gas stop

The euro has fallen to par against the dollar for the first time since the end of 2002 – since the beginning of the year alone, the euro-dollar exchange rate has weakened by around 12 percent. The common European currency has also weakened significantly against the Swiss franc. On Friday, only 0.98 francs were paid for one euro. The weakness of the European common currency has several causes.

A potpourri of reasons

Interest rate difference to the USA: “The main reason is the difference in interest rates,” says Martin Lück from the asset manager Blackrock. The US Federal Reserve is raising interest rates much more vigorously than the European Central Bank (ECB). Since March, the Fed has raised the target range for key interest rates from 0 to 0.25 percent to 1.5 to 1.75 percent. Now there is speculation that the central bank will change this in view of the very high inflation rate of 9.1 percent in the USA at its meeting on 09.12 July 27th could increase by another percentage point. Thomas Heller, head of investment at Belvédère Asset Management, also expects the interest rate gap between the USA and Europe to widen further due to the different monetary policies of the central banks. He therefore does not expect the euro to recover significantly against the dollar.

Lax European monetary policy: The ECB has so far remained silent on monetary policy despite high inflation rates. “Even if the ECB follows suit, the end point of the interest rate hikes will be lower than in the USA because the economy in Europe is weaker and the growth-neutral interest rate level is therefore lower,” says Lück. In addition, sharp interest rate hikes in Europe could call into question the stability of the euro zone.

Concerns about a deep recession: Another important reason for the weakness of the European single currency is concern about a significant economic slowdown in Europe. “The economic instability in Europe is greater than elsewhere,” says Heller. From Lück’s point of view, it is becoming increasingly clear how different the risks of recession are in Europe and the USA. “While in the US the slowdown would be triggered by a tightening of financing conditions, and this is likely to result in a rather short and shallow recession, in Europe the prospects will be defined by Russia’s incursion into Ukraine.”

Fear of a gas stop: The Ukraine war and its consequences hit Europe much harder than the USA. According to Daniel Hartmann, chief economist at the Bantleon finance house, the current weakness of the euro reflects the energy crisis and the risk of a complete Russian gas supply freeze. In such a case, the industry in some countries would probably have to reduce production. A gas stop threatens a deep recession, says Lück. “As a result, weighing the risks is prompting many investors to direct their capital to the United States. This supports the US dollar and weakens the euro.”

Dollar as a safe haven: In economically difficult times, investors look for so-called safe havens on the financial markets – these include the dollar and the Swiss franc. The crash of the cryptocurrency Bitcoin also shows that investors are fleeing risky investments, says Heller. However, when discussing the weakness of the euro, it should be borne in mind that the dollar appreciated against almost all currencies in the first half of this year, as Bank Helaba explains – not just against the euro. Only the most recent concerns about a gas supply stop would have put a particular strain on the common currency.

Instability in Italy: Added to all this is the government crisis in Italy. Prime Minister Mario Draghi wants to resign from his post there, but this was not accepted by President Sergio Mattarella. Seen alone, the political situation in Italy is only having a limited impact on the euro, says Heller. Together with the multitude of other problems, this increases the pressure on the common currency.

Excitement before the ECB meeting

The financial market players are now eagerly awaiting the interest rate decision by the ECB next Thursday. The market has priced in a rate hike of 0.3 percentage points. Given the inflation rate in the euro zone of 8.6 percent in June, this is “very manageable,” says Heller.

He expects inflation in the euro area to remain high unless the economy “stalls”. In recent months, economists have significantly underestimated the level of inflation. There is much to suggest that the outbreak of the Ukraine war was a kind of “game changer” that pushed inflation up by one to two percentage points and lengthened the period of high inflation accordingly.

Lück sees a risk of stagflation for the euro zone – that is, a phase with persistently high inflation rates and simultaneous economic stagnation. “Inflation will remain significantly elevated for a long time. Purchasing power erosion, energy shortages and other supply chain problems are also likely to stagnate growth,” he says.

Financial market players are also speculating more strongly on a potential collapse of the euro zone. The yield premium of ten-year Italian versus German government bonds has leveled off at higher levels. “In return, the ECB has become creative,” says Heller. This refers to the announced program to combat the fragmentation of the euro zone or the differences between the yields on government bonds. Heller expects that this will definitely help.

Risk of loss of confidence in the ECB

“The essential prerequisite for preventing future euro crises, namely the fiscal and social integration of the euro area, is still not in place,” says Lück. The recent rise in interest rates has therefore brought with it the fear that the heavily indebted countries in particular could be overwhelmed. If in the largest of these countries, Italy, there is also a government crisis, a further increase in risk premiums is likely. “The ECB would do well to develop more and better instruments to stabilize the euro area,” says the Blackrock representative.

One danger is an increasing loss of confidence in the European Central Bank in the currency markets. “With its hesitant course, the ECB risks discrediting the euro as a soft currency in the long term,” says Hartmann. The already existing undervaluation against the dollar should then become structurally entrenched.

According to Bank Helaba, however, long-term valuation indicators such as purchasing power parity currently show that the euro is heavily undervalued against the dollar – this can be explained by the reasons mentioned. But if things don’t turn out quite so badly for Europe, there is a noticeable recovery potential for the euro-dollar exchange rate, it is said.

Avoid currency risks

From Lück’s point of view, however, investors should expect weaker earnings growth, especially at European companies, in the coming months. “This should mean further downward pressure on prices,” he says. It may therefore be advisable to hedge investment portfolios against price fluctuations, for example by overweighting more defensive companies, he says.

According to Heller, recent developments have shown that a certain overweighting of the Swiss market makes sense for franc investors – after all, this is how they avoid currency risks. He advises hedging the currency risk when investing in bonds in euros. In the case of equities, there is a certain degree of automatic compensation, and hedging is less of a priority here.

Lück expects the franc to become even stronger against the euro. In the past, the Swiss National Bank (SNB) tried to prevent an undesirably strong appreciation of the franc so as not to damage the export economy. At the moment, however, a strong currency is definitely desirable in order to curb inflationary pressure, especially on the energy side. “This in turn limits the erosion of purchasing power in Switzerland relative to the euro area. Together with the lower dependence of the Swiss economy on fossil fuels from Russia, this reduces the risk of recession,” says Lück.