We expect the euro to continue weakening against the dollar in the near and medium-term, but to strengthen in the longer term. The dollar should continue to be supported by expectations of an eventual series of Fed rate hikes and the value of the dollar as a safe haven against a potential equity correction. The long-term outlook for EUR-USD on the other hand is shaped by productivity, ageing infrastructure, climate change and shifting political blocks suggesting that both the euro and dollar could strengthen against emerging markets.
Cyclical outlook – EUR-USD initially down
The market can only make wild guesses based in large part on the forward guidance from the Federal Reserve – forecasting at long horizons is very difficult and the record, as one can imagine, is not the best. Nonetheless, turning points in the dollar are often a function of Fed forward expectations up to two years which eventually collide with reality. As they do, inflation should initially fade faster than expected to then firm up. Indeed, much of the inflationary pressures we are seeing are linked to the supply chain which should partially fade, while there is no strong feedback loop between rising wages and inflation aside from low skill workers. Eventually though, the labor market will tighten enough for inflationary pressures to build up. That should give the dollar its next leg higher against the euro as the ECB should still be on hold for another year by then.
Long-term outlook – EM lower
The long-term outlook is defined by secular forces that are hard to forecast but defined with a hardening confrontation between East and West. It suggests over the long term a stronger EUR-USD but not one we can necessarily bank on, though fans of purchasing parity might. The odds are more that emerging markets currencies could weaken against the euro and dollar.
1. Productivity has been more a forté for the US, but there are signs that the EU is also making significant strides in that direction faced with lower potential growth in the long run.
2. Ageing is more of an issue for Europe than the United States, creating a greater demand for European fixed income and reducing potential growth to favor the dollar.
3. Climate change on the other hand strongly favors Europe even if we fail to reach our 2050 climate target of carbon neutrality, which we most likely we will. This is driven in part by likely greater investments in the Green Sector and far better geographical position. Climate is an inflationary cost and the odds are strong that many emerging markets will choose to offset this by weakening their currencies against the dollar. This should be especially the case for the euro which depends more on exporting to Asia.
4. Rising tensions between East and West means an inefficient rejigging of supply chains, at a time of a slower accumulation of savings in emerging markets and greater emphasis on avoiding dollar foreign reserves and exports, with reserve diversification in euros.
The downward trend in EUR-USD is likely to return in the coming weeks and months suggesting EUR-USD around the 1.10 handle and potentially below that before moving higher. Currencies are very much worth our interest. Without being invested in them, we lose much of our understanding of the overall economy, from emerging markets to developed markets. It is within the subtlety of EM bond investments for example that one profits from EM and DM equities.
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