Patterns in the euro-U.S. dollar currency pair will impact the loonie

Here in the latter half of June, we can expect the euro and United States dollar currency pair to miss its target. Those two currencies are known as the “king and queen,” so the pair missing its target will have a bigger influence on exchange markets.

New forces in the foreign exchange markets are at work, and will influence many pairs of currencies for months—and possibly years—to come.

These forces will also influence the U.S. and Canadian dollars pair, setting up a new long-term trend.

Right now, the euro-greenback pair is telling exporters, importers and investors to get their financial matters in order and prepare for interesting times.

Since 2008, the euro-U.S. dollar pair has fluctuated smoothly, reaching its targets, more or less, according to expectations.

Fluctuations were equally spread, providing equal trading and investment opportunities within European Central Bank (ECB) and U.S. Federal Reserve monetary policies.
Recently, however, the movement of the pair has become less dynamic and fluid. The daily, weekly and monthly movements are somehow restrained. The pair’s trend since the end of July 2012 to present day looks more like a corrective trend than a fluid movement.

The monetary, political and financial environments in both the U.S. and eurozone have definitely contributed to changes in the king and queen of currencies. The financial markets are dealing with complex monetary policies, a series of negative financial data coming from Europe and unexpected political events.

Without any question, the monetary policies of the Fed and ECB are playing major roles in shaping the movements of the two currencies.
On one hand, we’re in the middle of the Fed’s monetary tapering policy; and on the other, we’re seeing the ECB signal disappointment over its own monetary policy.
This disappointment culminates a long trend of complaints about high euro exchange rates.
The currency exchange rates between the euro and U.S. dollar have worked for the U.S. economy but have become a source of stress for the eurozone.

U.S. tapering continues

The Fed, encouraged by the growth of the U.S. economy, continues to taper persistently, restraining the decline of the U.S. dollar.

Although the Fed didn’t raise interest rates recently, it’s still signalling the tapering policy will continue.

Though some expect rising interest rates in the U.S. over a growing fear of high inflation, the persistent weaknesses in employment, low income growth, budgetary struggles, and relatively weak manufacturing could keep interest rates relatively calm for a number of years.

Moreover, raising U.S. interest rates would cause the greenback to appreciate in comparison to other currencies, and that would negatively impact American exports.
The Fed will likely use minimal interest rate raises combined with other tools to fight rising inflation.

The situation in the eurozone is drastically different.

The eurozone is in the midst of a heavy recession with a high risk of deflation. The ECB recently reduced its deposit interest rate to 0.1 per cent and European banks now pay the ECB to “park” their money.

The eurozone faces declining inflation that has reached 0.5 per cent recently, and a high unemployment rate of 11.7 per cent.
Export declines and falling imports suggest a dip in economic activity. Facing the risk of deflation that could last many years, the ECB has introduced a number of financial tools to pump money into the real economy and has signaled a willingness to “print money” if conditions worsen.

Clearly the ECB’s monetary policy hasn’t been enough to reach its target of two per cent inflation.
One of the roadblocks to achieving the necessary strong monetary policy is the difference in opinion between the German Bundesbank and the ECB.
Although the ECB’s influence is growing in Europe, the German Bundesbank doesn’t support a more aggressive approach in fighting deflation. The aggressive monetary policy with extremely low interest rates and printing money contradicts the German central bank’s recessionary policies and is highly unpopular in Germany.

It seems low interest rates in Europe are there to stay, and there’s no more room to lower them even further.

Low interest rate increases

In the U.S., we can expect slow and moderate increases of interest rates. Therefore, interest rates in the U.S. and Europe will diverge in the near future, and cause an uplift effect on the U.S. dollar in relation to the euro.

In my opinion, though, the degree of the U.S. dollar’s growth due to interest rate increases could be moderated by the Fed in its forward guidance on unemployment, exporting and manufacturing.

The present growth of the American economy is leading to moderate growth of the U.S. dollar that would bring the euro exchange rate into more reasonable territory for the ECB.

We can’t forget the U.S. dollar’s “safe heaven” status in financial markets. The label indirectly and favourably supports the ECB’s effort to lower euro exchange rate.

Without any question, the euro-U.S. dollar pair has been also affected by political instability between Russia and Ukraine.

The American dollar is treated, as usual, as a safe haven by investors in turbulent times and the declining value of the greenback in its pairing with the euro was also restrained by high demand imposed by the foreign investors withdrawing their assets from Russia and converting them into American currency.

The insecurity of the Ukraine-Russia relationship will continue to provide the uplifting effect on the U.S. dollar.

Looking at the strategic importance of international trade between the U.S. and Europe, it’s clear the U.S. needs a strong Europe and vice versa.

For many years, Americans and Europeans have adjusted their monetary policies to serve their common objective of helping each other in troubled times.
The common objective would see the Fed increase the value of the American dollar in comparison to the euro for a number of years. Consequently, the euro would decline in major pairs as well as in combination pairs with other “minor” currencies.
Such a currency movement would shift the export advantage to the European side and the import advantage to the U.S.

The U.S. dollar would appreciate in major pairs, including with the loonie, and, this time, the Canadian dollar’s depreciation would happen without the Bank of Canada’s involvement. This U.S. dollar positioning would begin a long trend of its appreciation in the currency pair with the Canadian dollar.
However, the shift in monetary policy towards a stronger U.S. dollar would put additional restraints on U.S. exports and the entire U.S. economy. Therefore, the decline of the euro in its pair with the greenback will depend on the strength of the U.S. economy and it will have a rather less radical trajectory.

Overall, under the assumption of ECB’s conservative monetary policy continuation (no printing money in the eurozone), I would expect a rather moderate and toned down crossing of the present belt’s lower resistant line, and consequently at the fourth quarter of 2015 the euro-U.S. dollar pair should oscillate at a level between 1.1800 and 1.2400.

The effect of an increased U.S. dollar in its pairing with the loonie will significantly increase Canadian exports to the U.S. and, naturally hedged in U.S. dollars, to other countries.

The increase of Canadian exports will also depend of the Canadian exporters’ ability to pass the currency exchange gain to the American and other foreign importers.
In the environment of Canadian dollar decline the Canadian importers would face more difficult times, therefore they should focus their attention on a “timely” capture of the currency exchange gain.

I also do not expect the dramatic inflow of European exports to Canada since the decline of Canadian dollar will be more steeper then the decline of euro.

Darek Wozniak is CanadianManufacturing.com’s currency guru.