Does the euro have a chance to get back on its feet?

The euro's decline last week came as quite a surprise to most market participants who were looking forward to a quiet trading session. Instead, all of a sudden, the euro hit parity with the US dollar for the first time in 20 years and then took a dive even lower. What prompted the euro's fall? We will try to find some answers to this question in this article. 

US dollar sets market tone

The catalyst for the euro's decline this week was the news from the US, where consumer inflation accelerated to 9.1% from a year ago in June, above the 8.8% Dow Jones estimate. As a result, the US dollar index marked a new twenty-year high, rallying above the 108.0 mark.

But is it all that bad in the US? Before the inflation report, the US Bureau of Labor Statistics published its monthly jobs report. Despite pessimistic moods, nonfarm payrolls rose by 372,000 jobs in June, higher than the estimated growth of 268,000 jobs.

The average hourly earnings increased by 5.1%, slightly above analysts' forecasts of a 5% rise. Based on these figures, we can conclude that labor demand in the country is rather strong, and there are no signs of a recession yet.

In addition, gas prices in the US have declined significantly over the past few weeks. Gasoline prices are also heading lower, while the price of Brent oil fell below $95 a barrel for the first time since February. Since the country isn't headed to a recession just yet, and price growth is slowing down, some investors went long on the US dollar, assuming that the Fed might not keep raising its rates as aggressively.

If earlier a rate hike by half a percentage point was considered aggressive, now if the Fed raises its rate by 75 points instead of 100, the market will see it as a good sign. By the way, 92.4% of market participants expect the US regulator to raise its benchmark interest rate 75 basis points in July. Two weeks ago, the likelihood of such a scenario was supported by 86.2% of market participants.

ECB pushed back against a wall

Although we can try and look for those to blame in this situation, in fact, it's the ECB that drove itself into a corner. Even before the pandemic hit, the European economy had already been showing signs of a slowdown. To support the region's economy in times of COVID-19, the ECB lowered the rate and had its printing press running at full capacity. As a result, the money supply in the EU reached critical levels, and excess liquidity began to pressure the euro. In addition, such ECB policy caused the balance sheet to rise to 80% of the Gross Domestic Product (GDP) of the Eurozone, while the balance of the Fed amounted to approximately 36% of US GDP.

It was the excess money supply that launched the process that we have observed for the last couple of weeks. Moreover, the difference between the Fed and the ECB monetary policies also weighs on the euro. The Federal Reserve began its policy tightening a long time ago. And while the US regulator makes every effort to put out the inflationary fire, the ECB keeps doing nothing. Why? The European economy is made up of 27 countries that have their own peculiarities. Although the monetary policy in the eurozone is single, it's complemented by country-specific fiscal and budgetary policies that are under national governments' responsibility. Everything is fragile here, and the regulator is afraid to make sudden moves to prevent this house of cards from collapsing.

In addition, countries within the European Economic and Monetary Union (EMU) have a different attitude toward a weak euro and hence towards exports and imports. Exports in the Netherlands and Italy exceed imports. These countries have a positive trade balance, and a weak euro currency contributes to an increase in the competitiveness of goods and, hence, the revenue. At the same time, Germany, France, and Spain have a negative trade balance. Therefore, with a weak euro, their losses from imports exceed their income from exports.

Besides, southern EU member countries have higher public debt, so they are more vulnerable to interest rate hikes. Also, rising interest rates will increase the cost of borrowing and reduce credit-financed investments by companies. Amid high recession risks, this is very undesirable.

Military conflict, sanctions and gas

The military conflict in Europe weakens the euro too. Brussels stepped in to support Ukraine, adopting a €1.2 billion assistance package and six packages of sanctions against the Kremlin. But as it turns out, it's not only Russia that suffers, but Europe as well. The region is now facing major supply chain disruptions, a growing food crisis and shortages of fertilizers. European corporations left the Russian market, which resulted in billions of revenue loss. And most importantly, the EU is now on the brink of an energy crisis. As a result, the EU risks entering the 1970s-style stagflation associated with economic recession, unemployment and high inflation.

Russia's biggest trump card is full control of the natural gas supply. And it may prove to be huge leverage over Europe. In the spring of 2022, Europe began to cut its gas imports from Russia. And then Russia closed its Nord Stream 1 pipeline for maintenance for 10 days. A number of European leaders have expressed their concerns that Russia might extend maintenance to further limit gas supplies, leading to greater economic losses in Europe.

What lies ahead for the euro?

Considering that Europe has already lost its leading position in the international arena, we shouldn't probably expect significant growth in the euro. Most investors hope for a correction, which could press the euro back above the 1.0000 level for a while.

So, what factors can contribute to the currency's growth or decline? Let's start with the US dollar. If the greenback keeps strengthening, which is a plausible scenario, given how serious the Fed is about stabilizing prices and tackling inflation, the euro will remain under pressure.

When inflation was below the 2% target, a weak euro was not a problem. But now, when the consumer price index (CPI) has hit 8.6%, imports of raw materials have become more expensive, hindering the economic growth in the region. At the same time, one should not rely on the Central European Bank. It simply doesn't have the tools to stop inflation and bring Europe out of the crisis. The only solution it could resort to is slightly raising the interest rate. But this will only provide some temporary support for the euro, as there are other negative factors affecting the single currency.

In the long term, much will also depend on how far Europe is ready to go in its confrontation with Moscow. If they reach consensus and gas supplies stabilize, the euro will have a chance to return above the 1.0000 mark, but it's unlikely to rise much higher.

Three factors will determine the euro's further price action in the short term. The first is a technical factor. The European currency is heavily oversold. Since the euro sellers have reached their target of pushing it below the dollar, they may start locking in their profits, which will push the euro to the surface.

Secondly, the ECB is expected to raise its key interest rate next week, which will also strengthen the euro.

 The third factor is the resumption of Nord Stream 1 supplies. If Moscow reopens the pipeline, as promised, the energy crisis fears will abate, lifting the market moods for the time being.