EUR/USD – Moving to parity and beyond?

For years, currency watchers have predicted the U.S. dollar and euro will trade at parity.

The two currencies are almost at that level, but the euro could go even lower in 2017.

Central bank policies and U.S. and EU politics are driving the currencies valuations and the trends in place are likely to continue.

For several years now, there have been widespread predictions that the U.S. dollar and euro would move to parity (an exchange rate of one to one). That day seems to finally be approaching. The dollar hit a 14-year high on December 20th, after a powerful post presidential election rally that began after November 8th. While the financial media is giving substantial coverage to the latest rally, it is only a continuation of a larger trend that began in 2014, when the dollar and euro began moving in opposite directions. Central banks and politics are behind the divergence. Neither force is likely to offer relief to the falling European currency in the first half of 2017.

The behavior of the dollar and euro over time can be seen in the chart below. It can clearly be seen that between 2007 and 2014, the euro and dollar danced around each other. In mid-2014, however, they parted company. The dollar began a rally phase and the euro declined into early 2015. After that, most of the movement for both currencies was sideways until November 2016. Then, the dollar broke out to new highs (the red circle on the right) and the euro fell to new lows. So what happened that set these trading patterns sin motion?

U.S. trade-weighted dollar represented by the black bars and Euro in dollars is the gold line

The big change in the respective performance of the two currencies took place because of a shift in central bank policy in both the U.S. and the Eurozone. The ECB (European Central Bank) started its quantitative easing (QE) program in January 2015, although it had telegraphed its intentions for months prior to that. This acted to weaken the euro. Around the same time, the U.S. Federal Reserve ended its QE program in October 2014 after 37 months of straight bond buying. It also let the market know of its plans in advance. This acted to strengthen the dollar. The euro had another tailwind, however. The EU parliamentary elections, held in late May 2014, saw euro-skeptic parties come in first or second place in most countries. While this result gave observers pause, no one thought at the time that it threatened the existence of the euro (that would come later). Nevertheless, the euro began its drop before the votes were even counted.

As can be seen in the charts below, the euro, in dollar terms, has actually been on a long downtrend since its peak around 1.60 dollars per euro in 2008. By December, 2016, the euro was trading just above 1.00. The trade-weighted U.S. dollar (the dollar versus the currencies of its largest trading partners) was mostly moving sideways between 2007 and 2014, then it broke out of its trading range to a higher range. In November 2016, it again broke out to yet another higher range. See chart.

The latest moves in the euro and U.S. dollar are also related to central bank policy and politics. In June 2016, to almost everyone’s surprise, BREXIT passed in the UK. This provided proof for the first time, that the EU could fall apart and consequently the Eurozone (the UK does not use the euro) and the dollar started to rally and the euro sold off (the UK pound sold off even more). In December 2016, the ECB announced it would extend its QE program to December 2017. Meanwhile, the Federal Reserve raised its Fed Funds rate by a quarter point (its second move up) and announced it expected three more rate increases in 2017. This is bullish for the dollar. There is no expectation that the ECB will raise rates in 2017, which is bearish for the euro.

The election of Donald Trump as president in November was also seen as bullish for the dollar and as giving credence to the idea that Eurosceptic candidates running in 2017 could win their races. Contests in Holland (March), France (April/May) and Germany (some time between August and October) will be critical. The Eurosceptic candidate, Geert Wilders, is expected to place first in Holland. The most important race, though, is in France. The Eurosceptic candidate, Marine Le Pen, is ahead in the polls. She has vowed to take France out of the EU. The euro would suffer a very sharp decline if she won. Despite her standing in the polls, the pundits don’t believe that she will triumph, just as they didn’t believe BREXIT would pass or that Trump would win.

The strength of the dollar and weakness of the euro should continue at least until the first four months of 2017, and possibly throughout much of the year. If the one-to-one exchange rate level is breached, the next strong support is the 0.92 dollars buying one euro. If that level is broken, there is no historical guide for where the bottom could be. Investors should avoid holding euros or euro denominated investments until the political picture becomes more positive and/or the ECB becomes less accommodative (or the FED reverses its hawkish stance). Until then, investors can purchase ETFs that provide long dollar positions, such as: UUP or USDU. The alternative is to hold ETFs that have short positions in euros, such as: EUFX, EUO, and DRR or short ETFs that hold long positions, such as FXE, ERO, ULE and URR.

Original Story