Will the U.S. Dollar be Worth More than the Euro?
The dollar can be worth more than the Euro, but it will need a lot of assistance. The primary catalyst will be for interest rates in the United States to decouple from those in Europe. If this situation occurs and the United States grows with elevated inflation levels while Europe experiences stagnation and inflation moderates, the dollar could be worth more than the Euro. While this forex trading situation is now as likely as it has been in nearly two decades, it will take significant capital flows and much higher interest rates for this scenario to take place.
Currency Policy
The currency policy of the Biden Administration is officially a firm dollar policy. While the president will not say this out loud, he might want a weaker dollar. The dollar is the most widely used currency worldwide, and most of the goods and services exported from the United States are quoted in U.S. dollars. When the dollar is weaker, it makes the items that will be exported more attractive to importers in other countries. For example, if the price of a car is $30,000, a European importer would see this as cheaper if the Euro was at $0.90 rather than 1.40. Most U.S. administrations have described their currency policy as a “strong dollar” policy, but none of those presidents want their exports to suffer due to a strong U.S. dollar.
What Makes the Dollar Strong?
Several factors make a currency strong relative to other currencies. Economic performance is at the heart of the currency’s strength. For example, if investors believe that a country is safe and the treasury will pay its debts, they are likely to purchase assets in that country. The assets could include debt, such as government bonds, or equities, such as stocks. A strong economy can attract foreign capital. It will also offset some of the debt that a country might have if it is a debtor nation like the United States. So, a strong stock market attracts foreign investment, increasing the demand for dollars and making it more attractive to countries with less robust equity markets.
Another factor that drives a currency is interest rate differentials. The interest rate differential is the difference between two countries’ sovereign yields. For example, if you subtract the German Bund yield from the U.S. Treasury yield, you can determine the interest rate differential.
Forex trading professionals use interest rate differentials to create a forward point and a forward curve. Each currency pair uses a forward rate for forex trading activity beyond the spot market. The spot market is a business that is transacted in which the settlement is within two trading days. If the settlement is beyond two trading days, a forward rate is applied to create a forward rate. To create a forward rate, forex traders use forward points, which are calculated by taking the difference in each country’s sovereign interest rates and dividing that number by the spot rate. The forward points are then added or subtracted from the spot rate to create the forward rate.
Will the Dollar Be Worth More than the Euro?
This scenario has happened in the past. The last time was in the early 2000s. The exchange rate EUR/USD moved below 1, down to 0.90. The decline in the EUR/USD occurred as the 10 year yield differential between the U.S. 2-year treasury yield and the German 2-year yield increased to 3%. This situation was the highest the yield differential had been for a decade and made it more attractive for investors to invest in dollar-denominated assets instead of German-denominated assets. If you held dollars at that time, you would be earning 3% if the spot market did not move, making holding dollars more attractive than Euros.
Additionally, riskier U.S. assets such as stocks reached an all-time high in early 2000. Capital flows had been piling into the United States, which required foreign asset buyers to purchase U.S. dollars to buy equities. The combination of strong capital flows and a yield differential that made the dollar a more attractive asset allowed the dollar to grow in value and become worth more than the Euro.
The Bottom Line
The current market environment is ripe for a situation where the dollar rallies and becomes worth more than the Euro. For this to occur, the Federal Reserve will need to embark upon a string of rate hikes which will drive the interest rate differential further in favor of the U.S. dollar. In addition, forex trading market participants will need to believe that the Fed is ahead of the curve and inflation is in check, allowing capital flows to come into the United States. The combination of these events could push the EUR/USD below one, making the dollar worth more than the Euro.
