by Brad Tank, Chief Investment Officer—Fixed Income, Ugo Lancioni, Head of Global Currency, Neuberger Berman
After testing the water in July, last week the euro again briefly plunged below parity with the U.S. dollar.
The euro going through parity is a notable event. But perhaps even more notable is how it is subject to enormous economic forces that, depending on how things play out over the coming weeks and months, could equally be very positive for the currency or the cause of an even greater fall. Is parity a threshold over which the euro has decisively crossed or a boundary marking its low point?
Currency pairs move chiefly in response to the interrelated forces of the absolute level of interest rates, interest rate differentials, relative inflation and growth outlooks, and capital flows.
Sometimes one or another can dominate, as we saw in the way the euro moved during the COVID-19 pandemic. EUR/USD traders swung from worrying about the highly uncertain growth impact in the early weeks to focusing squarely on the interest rate differential from the second half of 2020 onward, and additionally on capital flows out of euro assets during the recovery of late 2021.
When we were thinking about this back in February, we thought a newly hawkish European Central Bank (ECB) might redirect currency markets’ attention onto what were then the slightly brighter forecasts for the European economy versus the U.S., and onto the prospect of the absolute level of ECB rates climbing back into positive territory.
It was not a high-conviction view, but we saw the potential of positive policy rates to drag trillions of euros’ worth of negative-yielding bonds with them, triggering a return of flows back across the Atlantic and renewed strength for the euro.
Two weeks later, Russia invaded Ukraine.
Since then, the currency market has indeed redirected its attention—but it has landed firmly on the six-month perfect storm that has battered Europe’s economy.
Sanctions against Russia have severely disrupted flows of energy into Europe, occasionally exacerbated by periodic shutdowns of the Nord Stream pipeline. At the same time, Europe’s cyclical, export-oriented manufacturers have been hit by the fallout from China’s zero-COVID policy.
An economy uniquely exposed to the world’s biggest inflation and growth crises then endured a summer drought that parched the rivers that are such a critical component of continental Europe’s supply chains. Even the recent recovery in risk sentiment was bad news for the euro, as it appears to have sucked capital flows into rallying U.S. assets.
While some of these headwinds appear to be easing, there seems little prospect of a near-term end to the conflict in Ukraine. That likely means sustained energy-related pressure on Europe’s growth and inflation, and also an ongoing drag, via costly energy imports, on the eurozone’s otherwise robust current account balance—generally one of the euro’s most attractive characteristics relative to the dollar.
But there is potential even for this to turn into better news for the euro.
European gas prices are likely to remain high as long as Russia and Ukraine are at war, but are they likely to remain as high as they are now? It’s possible, but unlikely if the Nord Stream pipeline keeps running with at least some capacity. European countries are in fact replenishing gas stores ahead of the normal schedule, despite the costs, pushing up prices now, but making them more likely to stay under control this winter. That could ease some pressure on growth and the current account.
That would leave the eurozone with high inflation, but at levels where the ECB would have better hopes of getting on top of it with higher interest rates. With its new “Transmission Protection Instrument” to deal with unruly government bond spreads, the central bank has more freedom to hike aggressively. It also would have few qualms about rate hikes strengthening the euro, as that would help tackle imported inflation.
Rates markets have priced rapidly and aggressively for a more hawkish ECB. Interest rate differentials have been narrowing even as the euro has sunk due to pessimism on eurozone growth.
As we go to press, Fed President Jerome Powell may be using his Jackson Hole address to admonish markets for their recent loosening of financial conditions, and that could open rate differentials again and push the euro back below parity. Ultimately, however, we think currency markets appear too pessimistic about Europe’s economy and not cognizant enough of rising absolute levels of eurozone rates and yields.
This is not yet our high-conviction view. We remain essentially neutral and cautious on both the euro and the dollar. If the ECB’s rate hikes fail to tame inflation, the euro may not benefit no matter how high they go. And we favor other European currencies more, such as the Swedish krona and Norwegian krone, which are also attractively valued, but less exposed to the inflation crisis.
All that said, we think it may be time to question the idea that the euro is on an inevitable downward spiral.
Copyright © Neuberger Berman