The Euro’s parity party is on hold

It’s been two years since the European Central Bank decided to combat the region’s economic woes by expanding the supply of money, buying bonds and slashing interest rates to nothing. The moves effectively debased the euro, prompting a chorus of investors and strategists to opine that the shared currency would soon tumble to parity with the dollar for the first time since 2002.
Although such predictions failed to come true, the parity chatter is picking up again as the euro dropped this month to levels not seen since 2003. The cause: broad dollar strength brought on by the prospect of higher interest rates from the Federal Reserve. But as was the case two years ago, those counting on further euro weakness are likely to be disappointed.
The fundamentals backing the euro are suddenly looking up. The ECB’s quantitative easing program is working, engendering a positive trend in euro-area growth, manufacturing and inflation. Any of these mean that euro-dollar parity may not be the right trade. And even if it were to happen, parity isn’t likely to be sustainable.
That’s the reason the euro was unable to close below 1.04 per dollar in early 2015 when the ECB’s QE program was announced — and it’s also why subsequent support levels in 2015 were increasingly higher. Despite dropping to as low as 1.0341 earlier this month, the euro has been unable to hold below 1.04. As growth and inflation in the euro zone pick up, the ECB will need to reduce its monetary policy accommodation this year and shift to tightening in 2017. That reduces the chances of any sustained weakening of the euro, even if the Fed raises rates as expected.
The International Monetary Fund forecast this week that growth in the euro zone would be 1.7 percent for 2016, compared with 1.6 percent in the U.S. Although the IMF’s 2017 forecast of 2.3 percent growth in the U.S. is stronger than the 1.6 percent in the euro zone, there are risks to that outlook.
Gross domestic product growth doesn’t happen in isolation from foreign-exchange rates, and U.S. expansion in the first half of 2017 is at risk from the combination of a strong greenback and a yearlong recession of fixed investment through the third quarter of 2016 — which likely continued in the fourth quarter. In contrast, leading euro-zone indicators such as the German Ifo index indicate that investment and growth estimates for Germany and the euro area may be revised higher.
When comparing the euro zone and the US, it’s useful to look at purchasing manager indexes, which are critical bellwethers of growth. The euro-zone manufacturing PMI has expanded for 42 consecutive months. The compounding effect of month-over-month expansions is likely to further fuel growth and inflation. Although the US ISM manufacturing index recovered from contractions in late 2015 and in some periods of 2016, it still shows weaker gains than its euro-zone counterpart. In fact, the euro zone’s manufacturing PMI has posted stronger monthly increases than the U.S.’s ISM manufacturing index in 15 of the past 18 months.
The Trump administration is expected to implement Reaganesque tax cuts and FDR-like public works projects, but any dissonance in the narrative of dual fiscal stimuli during the first half of 2017 would reduce hawkish expectations for the Fed and weigh on the greenback. For the euro zone, the story of continued expansion is likely to continue, fueling a growing narrative of future reductions in monetary accommodation and subsequent tightening.
ECB policy makers meet Thursday, and the focus, as usual, will be on President Mario Draghi’s press conference and what he says about inflation. Consumer prices increased 1.1 percent in December from a year earlier, the biggest surge since September 2013. Although the pace of inflationary is still relatively slow, the acceleration was sharp — and unexpected.
And don’t buy into the notion that a breakup of the European Union is inevitable, dooming the euro. The euro may be the euro zone’s ugly baby, but EU members have to love it. Of course, they should love it given the recent sustained improvements in growth, manufacturing and inflation.

— Bloomberg

Jason Schenker is president and founder at Prestige Economics LLC