The euro recently rose to the highest level since May 2018 against the US dollar. The common currency has thus broken the upward trend that has existed since 2008 against the greenback. The reasons and the consequences for the euro and the capital markets.
The interest rate advantage of US investments leveled by the Fed’s zero interest rate policy, a significantly higher valuation of Wall Street. Today and a likely policy change in the US are currently lacking the imagination for a rising dollar.
At the same time, the risk of the eurozone falling apart, which has been weighing on the euro for years, has decreased significantly as a result of the decisive measures taken by the European Union in the fight against the corona crisis, including fiscal transfers to the weaker members. Given the deteriorating environment for the US currency and the global collapse in nominal yields, we expect the euro to remain strong against the US dollar.
In an upward trend since 2011
The US dollar has been in a long-term upward trend since 2011. On a trade-weighted basis, it rose by more than 40 percent up to the high in March this year. The reasons for this development were, on the one hand, a relatively favorable development of the American economy and, on the other hand, the considerably higher returns on financial assets quoted in US dollars due to their comparatively high nominal yields and a significantly better development of the US equity markets.
In 2011, the interest rate advantage of two-year US government bonds against their counterparts from the eurozone and Japan had bottomed out. Due to the different monetary policy developments (e.g. euro debt crisis in 2011/2012, tightening of monetary policy in the USA from 2014), the interest rate advantage of US bonds has increased steadily since then. This in turn, just like the massive outperformance of the US stock markets against the rest of the world in support of the financial crisis, supported the greenback.
Dollar overvalued now?
We now see the US dollar as overvalued due to this appreciation. The factors mentioned should no longer provide further support. On the contrary, in the wake of the corona pandemic, the Federal Reserve also lowered its key interest rates to zero. Announced that it will not raise them for a long time. As a result, the interest rate advantage of the US dollar has shrunk significantly in the foreseeable future. The US stock markets are also currently valued significantly higher than the rest of the world. Making sustained outperformance more difficult to achieve.
Policy change likely
There is also a high probability of a change in policy in the USA. In this way, the Democrats could be successful in both the presidential and congressional elections. Even take over the majority in the so far republican-dominated senate. As a result, corporate taxes are likely to be increased. It would directly reduce the profits available to shareholders and weigh on the stock markets. Finally, market technology is also pointing to a deteriorating environment for the dollar after breaking the nine-year uptrend on a trade-weighted basis.
Euro before long-term appreciation
On the other hand, we expect the euro to appreciate over the longer term. In the wake of the corona pandemic, the interest rate disadvantage of the common currency has decreased significantly. Compared to the rest of the world. Because the European Central Bank has not further reduced its already very low key interest rates. Added to this is the high current account surplus of 2.4 percent of GDP. Which leads to an annual inflow of around 300 billion euros. We also see a significantly positive factor for the euro in the introduction of the “Next Generation EU” development plan. This plan was adopted by the EU Council in July. The plan enables the economically weaker countries and those more affected by the pandemic. All this to make their fiscal policy more expansionary and thus more growth-friendly in the coming years.
In addition, the introduction of fiscal transfers should contribute to political stabilization in various countries in the eurozone. For example, Italy from a net payer to the EU to a net recipient of substantial payments. This should also stabilize the country politically. This reduces the systemic risk of the eurozone breaking apart. It has weighed on the common currency since the euro debt crisis. Accordingly, the net capital outflows from the euro are likely to decrease over the next few years and are accompanied by an appreciation of the euro.
Trend appreciation of the euro
Incidentally, the euro has already tended to appreciate in recent years – with the major exception of the US dollar – and has on a trade-weighted basis