Euro Trades Above US$1.50 for First Time

The euro is trading above US$1.50 for the first time since the Eurozone came into existence in January 1999. This is primarily a consequence of the dollar being undermined by further weak U.S. data heightening concerns over the U.S. economy and reinforcing expectations of additional interest-rate cuts by the Federal Reserve. Indeed, the dollar also sank to a new low on its trade-weighted index. The euro's previous record high against the dollar of US$1.497 had occurred in November 2007, and it had since largely traded in a US$1.44-1.49 range with its upside being limited to some extent by heightened belief that the Eurozone economy will increasingly struggle over the coming months in the face of serious headwinds. Indeed, latest Eurozone data and survey evidence have clearly been softer overall. Furthermore, the European Central Bank (ECB) appeared to move to a neutral monetary policy stance at its February meeting, having previously clearly held a tightening bias.

Outlook and Implications

Global Insight expects the euro to continue to be well-supported against the U.S. dollar over the first half of 2008, benefiting from improving interest-rate differentials. Although we do not expect the ECB to raise its key interest rate further from the current level of 4.00%, we suspect that the bank will be reluctant to trim interest rates before mid-2008 because of its concerns over medium-term Eurozone inflation risks. In contrast, the U.S. Federal Reserve is expected to trim its key interest rate by a further 100 basis points to 2.00% by the end of April, following a total 225-basis-point reduction between September 2007 and January 2008 to try to avert recession in the United States. The Fed is forecast then to keep interest rates at 2.00% throughout the rest of 2008.

Any worsening in U.S. interest-rate differentials dilutes a key support for the dollar. Along with weaker U.S. growth prospects, it increases the risk that the United States will struggle to attract the substantial net capital inflows needed to finance its current-account deficit. Indeed, we believe that the still-huge U.S. current-account deficit will exert a significant downward influence on the dollar over the long term. Crucially, the euro is likely to continue to account for a disproportionate share of the U.S. dollar's adjustment because of Asian policymakers' likely continuing relative inflexibility over their currency regimes. In addition, there is the very real possibility that several countries could switch a proportion of their foreign currency reserves out of U.S. dollars over time.

Against this backdrop, the euro is now seen trending up to trade as high as US$1.55 in the first half of 2008. Although Eurozone officials have become increasingly vociferous in their concern over the euro's strength against the U.S. dollar, this seems likely to have only a limited dampening effect at best. For a significant impact, it would almost certainly need joint central bank action to try to rein in the euro, and this currently seems unlikely. However, we expect the euro to start edging back from its peak levels in the third quarter of 2008 as the ECB trims Eurozone interest rates by 25 basis points in both June (to 3.75%) and September (to 3.50%). The Fed is expected to remain on hold after April, while growing hopes of U.S economic recovery may well help the dollar in the latter months of 2008. Specifically, we project the euro to ease back from US$1.55 at mid-2008 to US$1.47 at the end of the year.

The strength of the euro against the dollar adds to the increased pressures facing Eurozone growth currently stemming from tighter lending conditions, financial market volatility, elevated oil prices, and slowing global growth.

The most obvious losers from a euro trading around US$1.50 will be major Eurozone exporters to the United States as they will find their competitiveness impaired, on top of facing markedly weaker American domestic demand. Furthermore, Eurozone exporters will also be at a disadvantage against U.S. exporters in third-country markets, while Eurozone companies will also be less competitive in their domestic markets against imports from the United States and dollar-linked countries.

Furthermore, it will be more expensive for foreign companies and investors to invest in the Eurozone. Meanwhile, Eurozone countries will be a more expensive destination for U.S. tourists and shoppers.

Major beneficiaries from the strong euro will be tourists from Eurozone countries going to the United States and dollar-linked destinations for their holidays. Shopping breaks to New York and other U.S. cities will also seem particularly attractive. Eurozone consumers could benefit from cheaper prices for some imported goods.

There is also some good news for Eurozone companies. Given that oil, metals, and many raw material prices are typically quoted in dollars, the strength of the euro against the U.S. dollar should dampen firms' input costs. Similarly, companies and retailers who source a significant amount of their supplies/products from the United States and U.S. dollar-linked countries should benefit from paying less in euro terms. Meanwhile, Eurozone firms and investors will find it cheaper to invest in the United States.