Parity is the new reality for the euro

The internal value of the euro isn’t all that’s melting away at the moment like an ice cube in the sun in the face of soaring inflation rates. Its external value is also on a continual decline against the major alternative currencies (which is additionally worsening the inflation problem). Parity is the new reality for the European common currency. The causes behind its value depreciation have been largely self-inflicted, and a trend reversal is not in sight for the time being.


The new reality

From upper left to lower right. Anyone who is tracking the trajectory of the euro/US dollar or euro/Swiss franc exchange rate these days can just sit back and stare at the same corner of his or her monitor screen because parity has become the new reality for both currency pairs, and it has happened much sooner than most forex analysts expected. Even our own already bearish stance on the EUR/CHF exchange rate dating back to November of last year (see “How long until parity?”) has now been overtaken by reality faster than we thought. The EUR/USD exchange rate has plummeted intermittently by up to 12% and the EUR/CHF cross has fallen by more than 5% since the start of this year alone.


Easy to convert | One of the few benefits of the euro’s value depreciation

Euro vs. US dollar and euro vs. Swiss franc

Sources: Bloomberg, Kaiser Partner Privatbank


Interest-rate disadvantage…

Increasingly divergent monetary policies have been one of the biggest causes of the euro’s weakness in recent months. The US Federal Reserve has already raised its policy rate by 1.5 percentage points this year in the face of soaring inflation rates. And in the wake of last week’s latest upside inflation surprise (9.1%), another oversized rate hike of at least 75 basis points is on the agenda for the next FOMC meeting on July 27. Fed Chairman Jerome Powell may even copy the recent exploit by the Bank of Canada and raise the federal funds rate by an entire percentage point. The European Central Bank (ECB) deposit facility rate, in contrast, stands at just 0% even after this week’s surprisingly large 50-basis-point rate hike (instead of the 25-basis-point hike that the ECB had telegraphed and most observes had expected). Even the Swiss National Bank (SNB) took swifter action and bid farewell to its record-low negative policy rate (-0.75%) back in June. So in the wake of the ECB rate hike the euro remains the least attractive major currency both in Europe and arguably worldwide (with the exception of the Japanese yen) from an interest-rate perspective, espacially when inflation is taken into account. The real interest-rate differential between the Swiss franc and the euro ([Swiss nominal interest rate minus Swiss inflation] minus [Eurozone nominal interest rate minus Eurozone Inflation]) is particularly striking, for example – it towers at approximately 5 percentage points (!) at the moment.


…and self-inflicted problems

Besides interest-rate and inflation differentials, there is a plethora of other factors weakening the euro, a number of them being “self-inflicted” problems. This set of homemade problems particularly includes the heavy dependency of several Eurozone countries such as economic heavyweights Germany and Italy on Russian natural gas. Russian President Vladimir Putin is exploiting this dependence to use energy as an economic weapon. The Eurozone today is already teetering on the edge of a recession. If Putin doesn’t reopen the gas spigot to at least a certain minimum flow soon, a recession would be inevitable (see “(Icy) regards from Moscow”). There is an ever-mounting risk of a protracted period of stagflation in the Eurozone. Such a scenario would be detrimental to any currency, and it is arguably only partially priced into the euro at the moment. So, alongside the interest-rate factor, the economic activity factor likewise gives the euro further downward leeway. Moreover, the common currency’s fundamentals have already deteriorated markedly as well. The Eurozone’s trade balance, for example, recently swung to a deficit for two consecutive months (not least due to skyrocketing energy prices) for the first time since 2010. Its current-account surplus is at its lowest level since 2013, and foreign direct investment in the Eurozone stands at a 20-year low. Despite a few positive exceptions, the euro currency area evidently appears unattractive on the whole to investors.


The euro’s susceptibility to political instability is also hardly helpful for the currency. Especially in today’s increasingly multipolar world and in the midst of synchronous challenges caused by the Ukraine conflict, rampant inflation and the need to boost defense spending and accelerate the energy transition, it appears to be only a matter of time until tensions between social and political classes bubble to the surface more openly, the heretofore broad unanimity between European Union member states starts to crumble, and the unity of the currency and economic area comes into question again. The latest crisis of government in Italy does not exactly build confidence in this context, and it emblemizes two of the fundamental problems plaguing the euro: the economic divergences between the Eurozone member states and the growing mountains of debt. These maladies force the ECB to conjure up yet another new anti-crisis tool called a “transmission protection instrument” (TPI) at its latest policy meeting instead of focusing solely on stabilizing the value of the euro. Despite this new tool, ECB officials will likely have difficulty raising the policy rate level significantly above 1% in the quarters ahead. But if it is hardly possible to sustainably raise interest rates in the Eurozone to a higher level due to political considerations or the consequences for the public budgets of the countries on the southern periphery, in the longer term this would cement the euro’s status as a low-interest currency and thus as a “soft currency” at the same time.


Cheapness alone doesn’t help

The remaining euro optimists can legitimately cite two positive factors on the common currency’s side at the moment. In terms of purchasing power parity, the euro is now (significantly) undervalued, at least versus the overpriced US dollar. Moreover, the euro’s downtrend is so well established by now that many speculators are now shorting the euro and the currency is technically “oversold.” But although these last two points could spark a temporary retracement at any time, the cheapness argument does not lay an adequate foundation for a sustainable turn for the better. The euro looks set to perform poorly at first against the greenback in the medium term, even if a recession in the USA morphs from a mere risk to a grim reality. It would take a drastic cut in the federal funds rate, which could become a reality by as early as 2023 under a scenario of a not-improbable monetary policy error by the Fed, to enable a broader euro recovery.


Better off in a safe haven?

Against the Swiss franc, however, there are hardly any realistic scenarios that would give reason to expect a comeback by the euro in the medium term. The SNB proved its independence again this year and demonstrated its focus on the franc’s stability. The SNB likely will continue to actively use the franc in the months ahead as a tool for mitigating inflation, so a strong franc is entirely in the SNB’s interests. The contrast with the euro couldn’t be starker. The franc looks set to stay strong on the back of these monetary-policy circumstances and Switzerland’s better underlying macroeconomic conditions (e.g. near term: less energy intensiveness in Switzerland, for example; medium to long term: sustained high current-account surplus and low public debt), and the EUR/CHF exchange rate looks destined to veer even further southward. It therefore may make sense for investors who have the euro as their reference currency to rethink their currency exposure and to adjust it if need be. Whoever entertains the idea of doing that should be aware that alongside the Swiss Confederation, the Principality of Liechtenstein likewise benefits from the stability of the Swiss franc and offers a host of other advantages to boot (find out more here).


Oliver Hackel, CFA Senior Investment Strategist

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