In recent times, the European economy has faced substantial challenges that have significantly affected the value of the euroThe anticipated recession within the Eurozone stands as the primary factor contributing to the rapid depreciation of the euro, especially as the strength of the US dollar continues to riseObservers now contemplate the likelihood of the euro falling below parity with the dollar as a probable outcome.

Since July, the euro has consistently weakened, reaching record lows not seen since 2002. As of June's Consumer Price Index showing a staggering 9.1% increase in the U.S., the euro's value against the dollar briefly plummeted to 0.9998, raising concerns among investorsSimultaneously, the dollar index has experienced a steady rise, surpassing the 108 mark, a peak not observed in the last two decades.

The euro's downturn reflects growing concerns over an economic recession in the Eurozone

Advertisements

Data released on July 5 indicated a significant drop in the Eurozone's Composite Purchasing Managers' Index (PMI) to 52, marking a year-long lowThe service sector's PMI has declined for two consecutive months, indicating that the anticipated recovery is falteringThese economic indicators have contributed to a pervasive pessimistic sentiment among investors, driving the euro lower against safe-haven currencies like the dollar, yen, and Swiss franc.

A clear divide in economic conditions and monetary policies between the US and Europe has exacerbated the depreciation of the euroSince mid-2021, the euro has shown a distinct weakening trend against the dollar, a process that accelerated through 2022. The disparities in economic recovery and divergent monetary policies are pivotal in understanding the euro's position.

The sluggish pace of recovery in the Eurozone has placed additional pressure on the euro

Advertisements

Throughout the latter half of 2021, numerous European nations imposed lockdowns due to ongoing pandemic concerns, resulting in a recovery lagging prominently behind that of the USThe emergence of geopolitical conflicts at the start of 2022 introduced further downward pressures, primarily driven by energy shortages that have become critical to the Eurozone's economic stabilityMany European nations remain heavily reliant on energy imports from Russia, and the surge in energy prices, driven by supply shortages, has significantly impacted the economy, contributing to rising inflation in the region.

Notably, data reveals that in May, Germany saw its exports decline by 0.5% compared to April, while imports rose by 2.7%, leading to a trade deficit of one billion eurosThis marks Germany's first trade deficit since 1991. As a crucial engine of the European economy, Germany has felt the brunt of the ongoing energy crisis, which has inflated the prices of its exports while tight supply chains and increased shipping costs have driven profit margins down, dampening production and export willingness

Advertisements

As Europe's leading economic powerhouse, any crisis stemming from energy issues in Germany could have dire consequences for the entire Eurozone economy.

The fundamental differences in the economies of the US and Europe have led to a stark divergence in monetary policyThe International Monetary Fund (IMF) has downgraded its GDP growth forecasts for both advanced and emerging economies in Europe by one and one-and-a-half percentage points, respectively, to 3% and 2.7%. This adjustment is primarily due to the increasing prices of energy and food, which are severely hampering household consumption, and the uncertainty is stifling investment, leading to a pronounced underperformance of private consumption and investment in Europe.

In contrast, the US has been less affected by the conflict, with both the extraction and agricultural sectors benefiting from rising oil and agricultural product prices

• China-U.S. Economic Cycle Repositioning
• Profitability Starts with Loss Prevention
• Storage Market Recovers: HBM Gains Popularity
• AI Integration Reshapes Financial IT Services
• Power Battery Recycling Industry Set for Billion-Dollar Market

This situation has further intensified the divergence in monetary policies between the two regions: the robust growth in the US economy supports rapid interest rate hikes by the Federal Reserve, while the European Central Bank (ECB) grapples with balancing inflationary pressures against GDP growth.

The ECB's process of normalizing monetary policy lags behind that of the Federal ReserveFaced with growing inflation pressures, the ECB has hinted at raising rates beginning in July, with an end to negative interest rates planned for SeptemberHowever, this remains considerably behind the pace set by the FedBefore the conflict, the inflation pressures in the US were far greater than those in the Eurozone, prompting the Fed to engage in discussions and actions to normalize effectivelyAs the ECB accelerates its policy normalization to address high inflation, it may need to adjust this strategy should recession expectations continue to escalate and inflation reduce in the latter half of the year.

In addition to inflation driven by energy shortages, the dichotomy of a unified currency and fragmented fiscal policy places the ECB in a precarious position, facing dual pressures of soaring inflation and potential debt crises

In response to the pandemic, various nations introduced fiscal stimulus measures to revitalize the economyWhile Germany and France exhibited relatively strong economic dynamics, countries like Italy, Spain, Greece, and Ireland—collectively known as the "PIGS"—saw risk premiums soar amidst fears that unified interest rate hikes would stifle economic growthNotably, the yield spread on ten-year Italian government bonds surged to 4.2%, with a spread of nearly 250 basis points over German bonds, raising alarms over debt sustainabilityConsequently, the ECB finds itself in a constrained position concerning interest rate hikes, needing to balance inflation concerns alongside avoiding excessive lending cost increases for peripheral nations.

The Federal Reserve's aggressive rate hike trajectory has propelled the dollar index to new heights

Since November 2021, the Fed has consistently exceeded expectations regarding the tightening of monetary policy, with market pricing indicating a 100% likelihood of a rate hike of 75 basis points or more for the upcoming July Federal Open Market Committee meeting, and over 80% probability for a 100 basis point hike, potentially driving the federal funds target rate above 3.5% by year-endThe ongoing surge in the dollar index, exceeding the 108 level, reflects these developments and has reached a twenty-year high.

Despite a global trend towards de-dollarization, the dollar's predominant status in the international monetary system remains largely unchallengedIn cross-border payments, trading, financing, and reserves, the dollar typically comprises around or exceeds 50% of market shares, underscoring its unparalleled influence within the realms of global economy and finance

Since the onset of the COVID-19 pandemic in 2020, dollar assets have demonstrated a strong safe-haven appeal, with the dollar index notably rising during periods of market turmoil.

Moreover, heightened risk aversion fueled by recession expectations has also driven the dollar index upwardsAn inversion in the (10Y-2Y) yield curve of US Treasury bonds further implies that current market expectations have priced in an unsustainable tightening of monetary policy by the Federal Reserve.

Looking ahead, it appears that the euro is likely to continue its declineIn the near term, the pressures stemming from energy supply issues weigh heavily on the euro's valueAs the euro approaches the parity zone with the dollar, it has temporarily surpassed this thresholdThis parity level serves as a significant psychological barrier, with some technical support nearby

As of July 5, the futures market demonstrated a high short position in euros against the dollar, making negative impacts on the euro relatively muted by the influence of the short-selling forcesFurthermore, as of July 11, maintenance on Germany's primary gas pipeline from Russia could potentially limit supply, heightening uncertainty regarding future gas supply continuityIf Europe were to face a comprehensive gas supply cut from Russia, the euro would encounter even more pronounced downward pressures.

In the long term, recessionary conditions may impose limitations on the dollar’s growthThe euro could find breathing room amid the unwavering commitment from US and European monetary authorities to tackle inflationPresently, concerns around rapidly rising interest rates adversely affecting economic growth persist within the marketIn this context, the Federal Reserve is unlikely to shift its tightening posture easily, and expectations suggest the target federal funds rate could exceed 3% this year

Conversely, the negative impacts of the ongoing energy crisis present clear risks for the European economy, necessitating a more cautious approach to interest rate hikes by the ECBThus, unless there is a significant pivot from the Fed's monetary policy, the euro may lack substantial upward momentum.

Nonetheless, indications show that inflation in the US may marginally decrease during the months of July and August, leading the market to begin preparing for a potential cessation of rate hikesThis shift could temper the dollar's mounting momentum, potentially marking the beginning of a bottoming process for the euro.

In conclusion, the rapid and significant depreciation of the euro can be largely attributed to expectations of recession within the EurozoneThe euro currently lacks substantial support in both the short and long term