Euro has dropped below parity against the U.S. dollar for the first time in a long time, battered by growing recession fears in the euro area.

On July 13, the euro fell to as low as $0.9998.

Europe’s single currency started the year on a solid note before the war in Ukraine fuelled inflation and hurt the euro zone’s growth outlook.

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Here’s an outline of the importance of the move.

Many people might ask, “What is the big deal?”.

First of all, a drop below the $1 level is rare.

Since its birth more than 20 years ago in 1999, the euro has spent very little time below parity. As a matter of fact, the previous time the euro did so was between 1999 and 2002, when the currency sank to a record low of $0.82 in October 2000. Euro banknotes, as well as coins, were only introduced on the first day of 2002, with the euro only existing before that day as a unit of account for settling cross-border transactions.

Within its relatively short two-decade history, Europe’s single currency is the second-most sought-after currency in global currency reserves after the U.S. dollar. Moreover, daily turnover in the euro/dollar is the highest among currencies.

Euro and other currencies 

Euro is not the only currency that suffered losses against the U.S. dollar. The likes of the British pound and the Japanese yen have also declined this year, partly because more aggressive U.S. rate hikes have boosted the dollar’s appeal and also because concerns about the global recession have sent investors flocking to the safe-haven dollar.

The U.S. Federal Reserve increased rates by 75 bps in June.

Growing fears that soaring European gas prices make the euro area more vulnerable to recession risks also explain why the single currency is under pressure.

Unsurprisingly, some global banks forecast a recession for the euro area as soon as the third quarter.

One crucial question: Will the euro fall more? 

According to some economists, the answer is yes. Analysts believe that until the economic outlook improves, Europe’s single currency will remain in the doldrums. 

The single currency could be hurt by fragmentation risks, where weaker states’ borrowing costs rise by more than wealthier peers.

One favorable factor for the euro is that shorting the currency is already a popular trade in currency markets right at the moment, and bearish positioning is approaching historic levels. That might prevent the single currency from falling sharply.

And the last question: What does this mean for the European Central Bank?

To cut a long story short, a big problem. Letting the euro decline would increase already record high inflation, raising the risk of price growth becoming entrenched at a rate above the central bank’s target.

However, fighting back against 20-year lows for the single currency would require more rapid rate hikes and could create additional problems.

Studies regularly cited by the European Central Bank suggest that a 1% devaluation of the exchange rate raises inflation by 0.1% over one year and up to 0.25% over three years.

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