Will the Euro Outshine the Dollar?

by Sean Tweedie | December 3, 2020

Markets have celebrated the success of several vaccine trials which will hopefully pave the way for normalcy to return to the world in 2021. Around the world, equity markets have rallied on the good news. This past week brought some further good news on the pandemic front. The number of reported daily cases continues to trend lower in Europe. The 7-day average has now fallen by 30% from its November 8th peak. See Figure 1. In the US, there are faint indications that the number of new cases is stabilising, especially in the hard-hit Midwest. See Figure 2.


BCA Research – Figure 1

BCA Research – Figure 2


As a procyclical currency, the euro has also been quite cheerful. Bullish sentiment on the euro is at a decade high and the currency has rallied 11% from its recent lows, which corresponds with the drop in the DXY index (which measures the value of the US dollar relative to a basket of foreign currencies). See Figure 3.  Furthermore, 80% of speculators are bullish on the euro. Historically, sentiment at this level has been usually associated with the euro being closer to $1.50 per EUR.

BCA Research – Figure 3

The main driver of the EUR/USD exchange rate is the relative growth profile between the euro area and the US, how that profile is likely to evolve in the future, and the implication for relative monetary policies.

On the point of growth, the International Monetary Fund (IMF) projects growth in the euro area to contract by 8.3% in 2020, which is almost double that of the US, at 4.3%.

However, they also predict that by next year the economy is expected to bounce back more fervently. Euro area growth is expected to advance by 5.2% compared to 3.1% in the US. Much of the rise will be due to a surge in investment within the euro area, especially driven by pent-up demand in the peripheral countries (such Greece, Ireland, Portugal, and Spain). This growth acceleration is projected to continue well into 2023. There are two factors which, according to BCA Research suggests that the case for even stronger euro area growth persists.

First, the neutral rate of interest in the euro area may have moved higher relative to the US. The standard issue for the euro zone is that interest rates have always been too low for the most productive nation, Germany, but too expensive for others, such as Spain and Italy. The good thing is that the Euro¬pean Central Bank (ECB) has now lowered domestic interest rates and eased policy to the point where they are accommodative for all euro zone countries. This makes it much easier for the less-pro¬ductive countries within the euro area to borrow and invest. This will boost productivity and lift the neutral rate of interest together with the euro.

Secondly, peripheral countries in the euro area have become more competitive with the core countries (such as France and Germany).  This has seen unit labour costs between the core and the periphery converge.

According to the Holston-Laubach-Williams estimates at the New York Federal Reserve, the natural rate of interest in the euro area is now higher than in the US, something that has rarely occurred over the 20-year history of the common currency. The forecasts would suggest that the euro could gravitate towards the $1.5 level.

Since the 1960’s up until the Great Financial Crisis, trend productivity growth has been around 2.2% in the US versus 2.8% in the euro area. However, since 2009 this growth has been 1.1% in the US versus 0.6% per year in the euro area. Assuming that the crisis of the pandemic is behind us and European productivity growth returns to trend over the next 10 years while making up for the shortfall over the past few years, growth should be around 1.6% higher (cumulative rise of 20%) in Europe relative to the US. When looking at the fair value of the euro, purchasing power parity models suggest the euro is undervalued by around 10%. This would further suggest the euro could trade around the $1.5 level.

Ultimately, European growth is tied to export growth. With a huge concentration of cyclical sectors, such as financials, industrials, materials and energy, forming part of the European market, the euro tends to be largely driven by increased activity brought about by improving global growth.  So far, these signs have been positive. Credit growth in China has transpired into increased demand for European exports.  Even if social distancing remains in place for longer, countries which are more geared towards manufacturing such as Europe, Japan and China will remain well supported. See Figure 4.

BCA Research – Figure 4

The signs are pointing to firmer global growth next year as the world recovers from the pandemic. In an environment like this, your cyclical currencies such as the euro tend to do well, whereas the US dollar being countercyclical tends to sell off. The dollar remains expensive despite its recent sell- off suggesting it has more room to weaken over the medium term.  With the Federal Reserve adopting asymmetrical inflation targeting (which allows for periods of higher inflation) and with their commitment to extremely easy monetary policy (low interest rates), the long-term outlook for the dollar remains bearish.


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