The euro slipped below $0.99 to a fresh 20-year low on Monday after Russia’s halt to gas supplies through its main pipeline to Europe fueled fears of a deepening energy crisis across the region.
In recent months, the value of the common currency has become increasingly correlated with natural gas prices, with the euro falling as the price of the fuel has risen.
Europe is scrambling to wean itself off Russian supplies and build up reserves ahead of the cold winter months, but investors expect the impact on its economy will be huge.
The recent slide has been rapid: just before Russia started its war in Ukraine, €1 was worth $1.15.
Why is the euro falling?
The broader deterioration in the euro zone’s outlook amid rising gas prices and fears that Russia will cut gas supplies is dragging the common currency lower. The over-reliance on Russian gas for major economies like Germany and Italy has unsettled investors, and economists are predicting a much quicker and more painful recession in the euro area than in the US.
Added to this is the difference in interest rates in the USA and the euro zone. The US Federal Reserve has been more aggressive in raising interest rates to fight inflation. While the US Federal Reserve has hiked interest rates by a total of 225 basis points since March, the European Central Bank (ECB) has only hiked 50 basis points so far.
“The money would go to the place with a higher return,” Carsten Brzeski, chief economist for Germany and Austria at ING, told DW.
The US dollar is also benefiting from its attractiveness as a safe haven. Amidst all the gloom and doom and uncertainty surrounding the global economy, investors are finding solace in the relative safety the dollar offers as they are currently less exposed to some of the major global risks.
What is dollar parity?
Parity basically means that $1 buys €1. For market participants known for their penchant for round numbers, it’s nothing more than a psychological threshold.
“Financial markets always love to find symbolic meaning,” Brzeski said.
The parity level is often a point of resistance where euro bulls and bears will snap their horns to determine which direction the currency will go from there. Such was the case when the euro plunged towards parity last month. The currency avoided a close below parity after briefly falling to this level.
How will a weaker euro affect consumers?
A falling euro will put even more strain on European households and businesses already reeling from record high inflation. A weaker currency would make imports, mostly denominated in dollars, more expensive. If these items are raw materials or intermediates, their higher cost can further drive up local prices.
In normal times, a weak currency is seen as good news for exporters and export-heavy economies like Germany, as it boosts exports by making them cheaper in dollar terms. But then again, these are hardly normal times due to global supply chain conflicts, sanctions and the war in Ukraine.
“In the current situation with geopolitical tensions, I think that the advantages of a weak currency outweigh the disadvantages,” Brzeski said.
But for US travelers to Europe, a weak euro is a boon. For example, at the parity level, they could theoretically exchange their $1,000 in February for €1,000 instead of less than €900. In other words, their dollar would be worth a lot more. For companies importing European goods, things would be cheaper in dollar terms.
How low will the euro fall?
Bets that the euro would fall further have risen as Europe’s energy crisis deepens.
Strategists at Nomura International have forecast the euro could fall as low as $0.95. US investment bank Morgan Stanley forecasts the currency to fall to $0.97 this quarter.
As the European Union tries to wean itself off Russian oil and gas, it is looking for alternatives amid fears of blackouts and energy rationing. This has led to higher energy costs.
“A skyrocketing energy import bill is negative for the euro and our short-term forecasts through September continue to see EUR/USD hovering around parity,” wrote George Saravelos, Deutsche Bank’s head of FX research, in a note to clients.
“While the near-term impact of the ongoing energy crisis remains negative on EUR/USD, some of the medium-term European risks appear to have eased after the summer,” he said, referring to a surge in LNG imports and a much larger – than expected – fall in gas demand, as the industry switches to other fuels.
What does a weaker euro mean for the ECB?
A weak euro and the resulting price hikes are adding to the challenges facing the European Central Bank, which has been criticized for starting its rate hike cycle much later than its peers.
To make matters worse for the central bank, which is tasked with taming inflation, the euro has weakened not only against the dollar but also against other currencies such as the Swiss franc and Japanese yen.
“This is now becoming a bit broader euro weakness and therefore an inflation issue for the ECB,” Viraj Patel, FX strategist at Vanda Research, told DW.
The falling euro was one of the factors that prompted the central bank to announce a 50 basis point rate hike in July, double the June rate.
Edited by: Uwe Hessler