Panic appears to rule the world’s most liquid financial market, the foreign exchange market. The Bank of England had to announce emergency measures on Wednesday to stop the pound’s dump. Behind the panic is a systemic crisis: a dramatic fall in European currencies against the dollar, an analysis shows.
Not only the pound, but also the euro has been failing against the dollar for more than a year. Falling currencies are eating into investors’ returns and specialists believe that their devaluation against the dollar will not bottom out for the time being.
“Despite a more offensive ECB and the sharp rise in the dollar during 2022, we expect the dollar to remain firm against the euro with the potential for a further rise,” said Andrea Siviero, investment strategist at Ethenea. He does not expect the current pattern in the euro-dollar exchange rate to change soon.
The scenario of weakening global growth and high geopolitical uncertainty remains supportive for the dollar, according to Siviero. The currency benefits from an offensive US central bank and a resilient US economy.
US Dollar Currency Index
The US Dollar Index, the measure of the US dollar’s strength against a basket of six influential currencies (the euro, the pound, the yen, the Canadian dollar, the Swedish krona and the Swiss franc), added over 21 per cent over the past year and, unlike the rest of the market, is in a clear bull market scenario.
This index this week peaked at $114.6 before giving up some of its recent gains, falling slightly to $113 on Thursday. The old record of $115 dates back to May 2002.
Not only due to dollar strength
Thomas Mayer, former chief economist of Deutsche Bank Group and founder of research institute Flossbach von Storch, sees that the currency market no longer has confidence in the ECB’s determination to follow the Fed in fighting inflation, “when inflation is notably equally high on both sides of the Atlantic”.
Last month, US prices rose 8.3 per cent compared to August last year. In the Eurozone, inflation stood at 9.1 per cent last month. A less decisive ECB will ensure higher inflation in Europe than in the US in the medium term, according to Mayer.
“The ECB is on the hook for highly indebted eurozone countries, which are threatened with insolvency if interest rates rise sharply,” Mayer said. While the Fed raised its policy rate by 250 basis points since March, the ECB is severely slowed by the weak economic situation in the currency union and a widening of sovereign bond spreads within the eurozone, so-called market fragmentation.
As a result, Mayer said, “US interest rates are likely to rise faster and stronger in the near future and the interest rate differential between the US and the eurozone is likely to widen,” he wrote. He feels the strong dollar is only partly responsible for the waning euro.
Weak Europe
According to Mayer, there is currently nothing to suggest that euro weakness could also be caused by fears of a euro collapse. “Markets still believe in former ECB president Mario Draghi’s promise that the ECB will do everything it can to preserve the euro. But Draghi has retired from the ECB and soon from Italy. His actual and likely successors are less credible,” Mayer said.
Siviero said signs point to a eurozone recession in the coming quarters, posing a challenge to the ECB. “With high sovereign debt levels and marked regional divergences, the ECB’s tightening path remains a very difficult process. Tighter ECB policy may bring some short-term relief to the battered euro, but it is unlikely to reverse the current pattern of a weak euro.”
Canary in coal mine
Bruno Verstraete, partner at Swiss asset manager Lakefield Partners AG, said a moment of reversal in the euro-dollar exchange rate can only be foreseen once the Fed has overwhelmingly implemented enough (or too many) interest rate hikes. Buying additional dollars, he said, now only has its uses if growth expectations between Europe and America continue to rise in favour of the US.
Verstraete sees a clear shift from monetary stimulus to fiscal stimulus where governments support citizens. “This comes at the expense of budgets and causes even bigger problems with public debt. This combined with higher interest rates (albeit compensated for inflation) could become a very dangerous situation in countries with too much debt like Italy, for example,” Verstraete said in a response to questions from Investment Officer.
Pound panic
Italy’s problems are already old news as the Bank of England is once again providing monetary stimulus by buying up long-term bonds. The aim: stop the pound’s free fall.
“What is happening in the UK is an exponent of the problem I just described,” said Verstraete. ”The central bank is on the brakes. The government is accelerating. Markets are panicking over sovereign debt and dumping the currency.”
Ray Dalio, founder of hedge fund Bridgewater Associates, attributes the pound panic to the fact that the market has realised that the large supply of debt to be sold by the government is many times greater than demand. ”I cannot understand how those who were behind this move did not understand that. It suggests incompetence,” he wroted on LinkedIn.
Dalio, considered one of the world’s most influential investors, accused the UK government of operating like the government of an emerging country. “I can’t understand how those who were behind this move didn’t understand that. It suggests incompetence,” he wrote on Linkedin
This article originally appeared on InvestmentOfficer.nl.