Why the euro has tumbled to parity against the US dollar

July 15 (Bloomberg) – As the US economy went into meltdown during the 2008 global financial crisis, one euro was worth about 1.6 times the US dollar.

Now a combination of Europe’s front-line exposure to Russia’s war in Ukraine and the European Central Bank’s tardiness in raising interest rates have driven it to parity, or a 1:1 ratio with the dollar.

It’s the first time the euro has sunk to that level since 2002, in the early years of the currency’s existence.

WHY IS THE EURO SINKING?

Europe suffers most from the war, which has sparked an energy crisis and could lead to potentially a long and deep recession.

That places the ECB in a difficult position – trying to curb inflation and cushion a slowing economy – as it aims to raise borrowing costs for the first time since 2011.

At the same time, the US Federal Reserve is raising interest rates much faster than the 19-nation euro area. That makes yields on US Treasury bonds higher than those on Europe’s debt, driving investors to the dollar and away from the euro.

What’s more, the greenback benefits from its status as a haven, meaning that as the war drags on and the fallout gets worse, the euro keeps sliding.

READ: Why is the UK economy suffering more than other countries?

WHY IS A WEAKER CURRENCY A PROBLEM?

For years, policy makers in many countries have welcomed weaker currencies as a means to stimulate economic growth, since it makes their exports more competitive.

But now, with inflation in the euro zone at the highest since such records began, its weakness is undesirable as it fans price gains by making imports more expensive.

In June, euro-area consumer prices jumped 8.6 per cent from a year earlier. Some policy makers have highlighted a weaker euro as a risk to the central bank’s goal to return inflation to 2 per cent over the medium term, although the ECB does not target the exchange rate.

Still, when measured against other currencies apart from the dollar, the euro looks more resilient.

READ: U.S. consumer inflation rises to highest annual rate since 1981

IS THE 1:1 LEVEL IMPORTANT?

Yes. It’s a psychological threshold for the market.

The first time the euro fell to parity with the dollar was in December 1999, not even a year after its inception. Just like now, analysts then pointed to a widening in the spread between German and US bond yields and stronger US growth.

It was a dent in the pride of Europeans, who saw the common currency as an important political project and a rival to the dominant dollar.

Today, the euro is considered one of world’s key currencies for transactions and reserves, though hitting parity is still symbolic.

For the financial markets, currency traders expect turbulence around the 1:1 level given that billions of euros in options bets are linked to that big line in the sand.

WHERE’S THE FLOOR?

It’s hard to say. Some analysts predicted the common currency could slide to 90 US cents if Russia escalates the crisis by withholding more gas supplies to Europe.

Since the start of July, options traders have been laying more bets at around the US$0.95 level, with US$0.9850 potentially acting as a short-term bottom, according to trade data from the Depository Trust & Clearing Corporation.

Deutsche Bank strategists have calculated that a slide to US$0.95 to US$0.97 would match the all-time extremes seen in exchange rates since the 1971 end of the so-called Bretton Woods system, which linked the value of many currencies to the US dollar.

Still, those levels could well be reached if there is a recession, they said.

WHAT COULD SPARK A TURNAROUND?

The key is narrowing the interest-rate differential with other global bond markets.

By the time the Fed had delivered 150 basis points of interest-rate hikes in just three months, the ECB had yet to move, keeping its key rate negative.

While Europe’s rate setters have signaled the start of their hiking cycle – including a potential 50-basis-point increase in September – doubts are brewing over how long they can sustain it. Raising rates is harder for the ECB than other central banks.

That’s because the borrowing costs of more indebted euro-area nations risk spiraling out of control if investors begin to question their ability to sustain debt loads.

Even the hint that policy makers were planning to tighten policy quicker than some expected in June sent the Italian 10-year yield surging above 4 per cent for the first time since 2014.

Since then, investors have been more or less reassured by promises of a new tool to prevent unwarranted spikes in bond yields. But if that plan disappoints markets, they could begin to doubt how much tightening the ECB stands to deliver.

IS THIS AN EXISTENTIAL CRISIS FOR THE EURO?

No, although aside from pressure on its value, the common currency has faced challenges as a concept in the past.

Since its formation, naysayers have pointed out the difficulties of managing a monetary union of disparate economies. That became apparent most prominently during the euro zone’s 2012 sovereign debt crisis, as investors started to shun the assets of more indebted countries such as Greece, Italy and Spain.

The rise of euroskeptic politicians in Italy and elsewhere has also provoked concern over the resilience of the bloc.

A defining moment was in July 2012, when ECB President Mario Draghi pledged to do “whatever it takes” to save the common currency.

Still, direct intervention to support the euro in the foreign exchange markets is rare, although central banks did take action in 2000.

WHO BENEFITS FROM A WEAKER EURO?

On a broader level, the euro’s weakness against the dollar helps European exporters as it makes their products more competitive and boosts earnings.

The Americas account for more than 40 per cent of sales for 70 European large companies, including Sanofi and Aegon NV. It also comes as a relief to US travelers to Europe, reducing the cost of their trips, and assists Americans at home battling their own imported inflation.

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