The euro exchange rate has been falling for months and now after a period of 20 years, it is once again at the same level as the US dollar. A year ago, one euro was exchanged for $1.20, and by the beginning of 2022, it had already plunged to $1.13. Since then, the depreciation continued and culminated in a brief parity with US dollar on Tuesday last week, before dipping below $1 on Wednesday.

There are primarily two main reasons for the drop in value of the euro, one being the soaring inflation in the euro area which currently averaging 8.6 per cent in June among the 19-member block. This rising trend is on the back of higher energy prices due to the Russia-Ukraine conflict. Indeed, Europe is by far more affected by the spike in energy and food prices in view of its proximity and dependency on the region, which could potentially lead it to experience 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 economy has been far less affected by the Ukraine war, which has thus far remained somewhat immune to the volatility in oil and gas markets, given their oil reserve and use of alternative sources of energy.

Moreover, in contrast to Europe, US interest rates have been rising for several months now, which makes investments in the US dollar area far more attractive. This is in addition to the strong demand for dollar driven by its safe haven status at times of war.

While raising interest rates might be the first step for the euro to recover, the ECB is caught in the worse dilemma a central bank can face: on the one hand inflation is soaring and requires an increase in interest rates, on the other hand, the eurozone’s growth is anemic and would benefit from low interest rates.

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 fact, about half of imported goods in the eurozone are invoiced in dollar, so the pass-through from a weak euro to high inflation is inevitable as more euros are needed to pay for those imported goods.

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% 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 than plan disappoints markets, they could begin to doubt how much tightening the ECB stands to deliver.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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