The euro is indeed likely to remain under downward pressure over the next few weeks, with economic indicators expected to confirm both the US economic lead and negative inflation in the euro area. Nevertheless, it is by no means a foregone conclusion that exchange rate developments will resemble a one-way street this year. The picture is likely to change as the year progresses. The movements on the foreign exchange markets are based on the expectation that the Federal Reserve will start nudging up interest rates this year – in line with its communication. However, these plans are not set in stone, but are data-dependent. As long as economic growth remains solid, the Fed is likely to view the mainly oil-price driven drop in consumer prices as transitory and forge ahead with its plans to abandon its ultra-loose monetary policy. If, on the other hand, growth surprises on the downside, the key rate hikes could certainly be postponed. The likelihood of such a scenario is by no means insignificant.
First of all, it is important to bear in mind that the US dollar has been under broad upward pressure since the second half of last year. The US currency recently gained further ground not just against the euro, but also against other major currencies such as the pound sterling and – following the Bank of Canada's surprising decision to cut key rates – the Canadian dollar. All in all, the trade-weighted external value of the US dollar has risen by almost 10% in recent months. This means that, in the course of the year, external trade is likely to put more and more of a damper on US growth. The exchange rate developments to date are expected to push exports down by around 3 percentage points in the course of year. What is more, the drastic slump in oil prices will likely trigger adjustments to investment activity in the oil sector, weighing on business investment momentum. If the US dollar were to continue to rise sharply in the short term, US growth would doubtless take a knock. Such a perspective would take pressure off the dollar.
Consequently, any marked appreciation of the US dollar is not likely to be sustained.
On the other hand, the weak euro, coupled with the downward slide in oil prices, could create the potential for positive surprises in Europe. Once it is evident that the economy is returning to a firmer recovery path thanks to this positive impetus, international investors are likely to start paying more attention to the European stock markets (again) given their more attractive valuation levels compared with the US. The resulting inflow of capital would provide a corresponding boost for the euro.
There are also developments under way that – from a longer-term perspective – could prompt international investors to rejig their portfolios to the benefit of the euro area. Since 2012 the euro area has been recording sizeable current account surpluses. Surpluses of 2% and more of gross domestic product have never been achieved before since the single currency was introduced. This year is likely to bring another marked improvement due to the plummeting value of oil imports. Although a large part of the surpluses generated in the past can be attributed to cyclical factors, the efforts made by the countries on the eurozone periphery have also served to boost competitiveness and also contributed to the surplus, which should be sustained for some time. A prolonged phase characterized by a very weak euro would only bolster this trend further. Sustained high current account surpluses would ultimately turn the net international investment position around.
All in all, the marked exchange rate shifts that we have witnessed to date can be expected to set various feedback mechanisms in motion, supporting a turnaround in currency trends. Even if the euro continues to tend towards parity with the dollar in the near term, this will not result in any sustained substantial weakness in the euro. Economic policymakers should resist the temptation to fuel expectations of a need for further euro depreciation. Last but not least, they should bear in mind that the resulting exchange rate volatility creates a more uncertain environment for trade and investment decisions. On the other hand, sustained exchange rate mispricing increases the risk of capital being misallocated and can stoke political tension.