The euro pressure against dollar
The latest remarks by ECB president Mario Draghi do nothing but confirm that Europe’s highest monetary institution is in no hurry to raise interest rates from their current –0.4%. On the other side of the Atlantic, alternatively, the discourse from the US Federal Reserve is indicating at least one further rate hike in 2017, thus accumulating four increases in 18 months. Such an outstanding difference makes the dollar more attractive than the euro in the medium term.
From the following graph we can see the rate hikes introduced by the Federal Reserve from 2014 (in orange), whilst the ECB (in grey) has been lowering theirs until they have dropped into negative figures.
We observe that Donald Trump’s economic agenda and his healthcare and tax reforms have added short-term noise to the euro/dollar exchange rate.
Hence the European currency has become overvalued against the most foreign currencies, but against the dollar in particular. In the medium term, the interest rate differences will eventually mark the most attractive region for obtaining yields from capital; we therefore think that once the political news disappears, the euro will depreciate substantially against the dollar.
Our currency valuation models using real interest rate spreads are indicating an exchange rate target in the medium term (6 – 12 months) of 1.07 dollars to the euro, from the current rate of 1.16. In the long term, we continue expecting rate spreads between the two regions to get wider rather than narrower, in particular due to the spreads in expected economic growth and hence in expected inflation; we would tend to think that, on a horizon exceeding one year, exchange rate parity between the euro and the dollar (€1 = $1) is not at all unlikely.