This way your euro will soon be worth a dollar

The dollar is very close to the 1:1 mark compared to the euro. In the past, the US currency has been worth more than the European one. Another lesson from history, however, is that this boundary is not easy to pass.

The beginning of the summer was the go-ahead for the US dollar in 2021 to start a significant advance. In just over twelve months, the currency has appreciated by more than 16% against the euro. This increase has nothing to do with the change of the seasons, but everything to do with developments in the interest rate markets. The Federal Reserve raised interest rates by 0,5% to 1% last week. And that seems just the beginning.

On the CME Group exchange platform, traders are pricing in an almost 80% chance that US interest rates will rise to more than 3% within a year. Such an increase was unthinkable six months ago. But the escalating inflation is forcing the Federal Reserve to tighten the interest rate handbrake firmly.

More conviction
The US central bank is doing this with much more conviction than its European counterpart. The difference is partly explained by the European Central Bank (ECB) fears that rapidly rising interest rates will slow down economic growth – already under pressure from the war in Ukraine. Moreover, the European economy is a lot less dynamic than the American one. Wage developments are determined via collective labor agreements, so that inflation does not provoke such sharp salary increases as in the United States.

The growing interest rate differential at least explains the strength of the dollar. Moreover, the prospect of the difference only widening makes it very easy to anticipate a further appreciation of the US currency to a level where a dollar is worth as much as a euro.

Two interesting insights
In this regard, the past harbors two interesting insights. In the first place, a dollar worth as much or more than the euro is not nearly as strange as you might think. At the end of 1999, the coin shot through the 1:1 mark to stay there for years. The euro even fell so far that in 2002 you only got 0,8 dollars for the currency. As now, the dollar's rise was caused by rapidly rising US interest rates.

To curb inflation of more than 3% and to prevent the economy from overheating, the Federal Reserve raised interest rates to more than 6,5%. At the time, interest rates in Europe did not rise above 5%. When the internet bubble burst in the autumn of 2000 caused a recession, both central banks cut interest rates again. Still, the dollar remained strong for several more years; partly because of the great geopolitical uncertainty.

A second dollar insight is that it is far from certain that the 1:1 limit will actually be reached. In the spring of 2015 and early 2017, the dollar was about as expensive as it is today. In both cases, the US currency lost ground again. The strength of the psychological resistance around the euro/dollar of 1,04 should therefore not be underestimated.

Joost Derks

Joost Derks is a currency specialist at iBanFirst. He has over twenty years of experience in the currency world. This column reflects his personal opinion and is not intended as professional (investment) advice.

© DCA Market Intelligence. This market information is subject to copyright. It is not permitted to reproduce, distribute, disseminate or make the content available to third parties for compensation, in any form, without the express written permission of DCA Market Intelligence.