If you believe the forecasts of a growing number of major banks, the dollar’s third-quarter surge is the start of a seismic shift in exchange rates that politicians and central bankers will be unable to ignore.
From $1.27 on Friday, predictions by some of the currency market’s top 10 banks including Goldman Sachs, Barclays and Morgan Stanley point to the first retreat for the euro to parity or near-parity with the dollar in more than a decade.
That is scarcely justified by a trade and balance of payments picture which already shows Europe, largely thanks to Germany, in substantial surplus.
Rather, it is a measure of economists’ doubts about euro zone growth prospects and their assumption that, after years of low interest rates, a radically weaker currency is the only plausible weapon left to the European Central Bank.
That has wide-ranging consequences and there were the first signs this week of discomfort both on U.S. stock markets and from Federal Reserve policymakers.
“If the dollar were to appreciate a lot, it would tend to dampen inflation. So it would make it harder to achieve our two objectives,» Federal Reserve Bank of New York president William Dudley said this week, referring to inflation and growth.
“Obviously we would take that into account.”
As yet it is a far cry from the «currency war» charges levelled by some developing economies in 2008 and 2009, but Dudley and other supporters of loose monetary policy may find themselves repeating their mantra over the coming year.
With U.S. midterm congressional elections in November, a further rise in the dollar may also draw protests from politicians, particularly those in constituencies with a heavy manufacturing and industrial base.
On the other side of the coin, Prime Minister Shinzo Abe was the latest Japanese policymaker to express concern this week at the scale of the yen’s slide.
“Dudley’s comment was a truism, not citing any particular alarm,» said Daragh Maher, senior currency strategist at HSBC in London. «But verbal intervention is a trend that will stay with us if we continue to see these moves in exchange rates.”
By some measures, the dollar’s rally has already been remarkable. It is on course for its biggest quarterly rise in six years and this week marks its 11th straight week of appreciation, the longest upswing since its link to the gold standard was broken over 40 years ago.
Its range against the euro over the past decade — roughly $1.20-$1.50 — remains unbroken and seasoned market-watchers warn that similar bullish dollar predictions in previous years have fallen flat.
This time may be different because after six years of financial and debt crisis from which it has yet fully to escape, many feel only a genuine change to the financial status quo can get the euro zone growing more robustly.
“It will be a structural shift because the euro zone needs one,» says Marvin Barth, European head of currency strategy with Barclays, the world’s third biggest currency trader.
Barclays this month cut its forecast for the euro for next year to $1.10 and Barth said that may only be the start.
“We think the euro is already just below fair value against the dollar, so that gives you some idea of the extent of the undervaluation (the euro zone will need),» he said.
“All of these trends support a multi-year devaluation in the euro … so yes, the logical conclusion of that is a move towards parity.”
Long before then, however, things get a bit foggy.
Deutsche Bank’s new forecast for the euro is $1.25 by the year end and the bank assumes that within six months the European Central Bank begins the outright bond-buying that Germany’s Bundesbank has so far steadfastly opposed.
But others say their forecasts do not price in outright QE – just the threat of it, or more simply the fact that euro zone interest rates will stay low while those in the United States rise.
That in turn raises problems.
All things being equal a strengthening currency dents the competitiveness of a country’s imports and thus hurts growth. It also helps cap import costs and therefore inflation, making it effectively a de facto tightening of monetary policy.
“In essence a stronger dollar represents a monetary tightening and thus, if it persists it could argue in favour of a delay either to the start or to the pace of Fed rate hikes,» said Jane Foley, a strategist with Rabobank in London.
The Fed also turned very cautious at the start of 2014 after its reining in of bond-buying stimulus provoked a rout on emerging markets. If Thursday’s sell-off on Wall Street was anything to go by, more bumpy days on markets may follow.
Given those barriers, Credit Agricole’s senior euro zone economist Frederik Ducrozet points to the importance of a paragraph in the ECB’s new staff forecasts that provides for an alternative scenario where the euro falls to $1.24.
“It was almost explicit. For the first time ever the ECB wrote that if the euro goes as low as $1.24 then inflation would go back to target in 2016,» he said. «They don’t want, incidentally, to push it too low, down to $1.20.”