Since the middle of May, the dollar has fallen by more than 8% against the euro. Historically, such currency swings are by no means unusual. That said, we were somewhat surprised by the sudden strength of the euro against the dollar.
Exchange-rate forecasts are tricky affairs. Since they always involve two countries or currency areas, what counts is how one compares to another. How the price level in one country evolves relative to the price level in another country, for example. This concept is known as purchasing-power parity and a very simple but useful way of implementing it is to look at the prices of specific fast-food products that are available in a lot of different countries. Foreign trade figures can also provide clues, as do the relative developments of interest rates in different countries.
None of these approaches can explain why the dollar has weakened so much against the euro in recent months. Instead, it looks as if the determined efforts of European policymakers have caught markets by surprise. Thanks to radical measures to contain both the Covid-19 pandemic and its economic fallout, the number of infections in Europe declined significantly in May. In the United States, by contrast, there was another strong increase in June and July. In addition, Germany gave up resistance to a transfer union, partnering with France to launch an EU reconstruction fund.
Positioning was another driver for the dollar correction. Earlier in the year, many market participants in the currency futures market had positioned themselves for a weaker euro, as our Chart of the Week shows. With the stronger euro the positioning has also shifted. Currently, bets on further dollar weakness are at their most extreme since 2018.
That suggests most of the good news for the euro is priced in, leaving scope for negative surprises. Covid infections are currently rising again in Europe, while they are falling in the United States. November’s U.S. elections loom large. From a market perspective, it could bring unwelcome changes such as tax increases. Polls have strongly swung in favor of the Democrats. However, they could easily swing back in Republicans' favor. We also expect further U.S. fiscal measures in coming weeks, while the EU reconstruction fund is unlikely to expand further. "Overall, it’s still way too early to write the dollar’s obituary," explains Stefanie Holtze-Jen, Chief Currency Strategist at DWS. After a temporary phase of weakness, we rather expect the greenback to strengthen again.
Sources: CFTC Commodity Futures Trading Commission, Haver Analytics, Federal Reserve Bank of St. Louis, DWS Investment GmbH as of 8/4/20
1. €750 billion fund agreed upon by the heads of government of the 27 European Union member states on July 21st, 2020 to benefit the countries most affected by the consequences of the Covid-19 pandemic. The fund is divided into grants of €390 billion and low-interest loans of €360 billion.