Implications of the US Dollar breaching parity with the Euro

by Evan May and David du Plessis | August 4, 2022

Implications of the US Dollar Breaching parity with the Euro

On 12 July 2022 the dollar hit parity with the euro for the first time since 2002. For the dollar to trade at parity, it is implied that USD 1 is equal to EUR 1. While parity does not have direct economic implications on the Eurozone or the US, barring benefitting European exporters and providing relief to American tourists, it is a significant symbolic and psychological level that caught the attention of the global forex market this year. At the moment parity is an indication of the strength of the US dollar amid fears of a global recession and the weakness of the euro due to uncertainty in Europe.

Inflation in the US, as measured by the Consumer Price Index (CPI), jumped to its highest level in four decades at 9.1% on a yearly basis in June from 8.6% in May

Europe is facing a potential energy crisis due to the ongoing war between Russia and Ukraine. Russia supplies 40% of Europe’s natural gas supplies and has cut the supply of the Nord Stream Pipeline, the single biggest pipeline in Europe, to 20% of its maximum capacity citing maintenance as the reason for the cut in supply. With Eurozone inflation at 8.9%, further economic constraints do not bode well for consumers. Annual GDP growth of the Eurozone is down 1.4% year-on-year. The Eurozone’s proximity to war means that economies in Europe are at a higher risk of supply side inflation, driven by a decrease in the supply of goods, relative to the supply dynamics in the US.

Across the Atlantic, the US is also facing astronomical inflation rates, with headline inflation being reported at 9.1% in June 2022 – the highest level since 1981. Such a surge in the price level was primarily driven by rising energy prices (41.6%) and food prices (10.4%). Relative to the European Central Bank (ECB), the Federal Reserve is seen as being more well-equipped to tackle inflation, given its aggressive interest rate hikes since March 2022. This is because the Fed can increase interest rates faster and more aggressively than that of the ECB. As a result, the Fed is seen globally as the most reliable central bank to halt rapidly rising inflation rates, with other central banks such as the Bank of Canada, the Bank of England, Reserve Bank of Australia following the footsteps of the Fed’s tighter monetary policy. This confidence in the Fed has resulted in an extremely positive outlook for the dollar, and as such, the dollar continues to strengthen amidst the fears of a global recession.

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As noted in a report by BCA Research, it is given that as markets increasingly price in the probability of a recession, especially in Europe, the dollar will rise relative to its peers. BCA Research has noted that the dollar has already priced in a recession, deeper than was the case in 2020. The Fed hiked interest rates by 75 basis points in July. This was as expected but given what the Bank of Canada delivered on July 13th, a 100 basis point hike was a hint to a potential upcoming distortion in interest rate differentials between various economies. More importantly, interest rate differentials (real and nominal) are increas­ingly moving against the US.

The strength of the dollar more than anything is what drove the EUR/USD exchange rate to parity and below to trade at a low of 0.9952 on 15 July 2022. The DXY Index, which tracks the strength of the dollar by benchmarking it against a basket of six currencies, reached a 20-year high in July 2022 at 109.29. As fears of a global recession looms the dollar became the safe- haven of choice, driving up the value of the dollar, while in Europe political and economic uncertainty saw the euro weaken at the same time. This 20-year high is fuelled by the large inflows into US Treasury notes and bonds, along with the dollar being used as a hedge to protect against the downside of the euro.

In order to combat the strength of the dollar and help the euro gain some ground, the interest rate differential between the US and the Eurozone needs to be narrowed by the ECB.
The Fed has increased the interest rate in the US by 225 basis points in 2022 compared to the ECB’s one and only increase of 50 basis point in July. Unfortunately, the ECB cannot tighten monetary policy as aggressively as the Fed, due to some European nations being more indebted than others despite Eurozone inflation surging to a record high of 8.9% in July 2022. Large interest rate hikes could result in an inability for some nations to sustain their debt levels and impair future economic growth prospects.

However, the dollar is severely overvalued which could trigger a large sell-off and a subsequent drop in its value. This may assist the euro in regaining most of its losses that was shed against the greenback earlier in 2022. However, if the Fed is able to maintain its current position as the most credible central bank in the fight against inflation, paired with the ECB lagging in terms of its monetary policy, rising inflation and continued uncertainty caused by the war, this result may keep the EUR/USD trading close to parity for the remainder of July – where a pullback below parity remains on the cards in the coming months.


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