What euro-dollar parity means for investors

In theory, the relationship between interest rates and exchange rates is straightforward: higher rates attract foreign investment, increasing demand for the currency and leading it to appreciate. The reality, as ever in economics, is more complicated.

At the start of the year, markets were expecting a steady stream of interest rate cuts from the Federal Reserve over the course of 2024. After reams of resilient data releases, it now looks clear that these won’t materialise. Even US policymakers seem to acknowledge that the Fed will be a laggard in this cutting cycle. 

After the US central bank’s latest meeting earlier this month, chair Jerome Powell said that “the difference between the United States and other countries that are now considering rate cuts is that they’re just not having the kind of growth we’re having”. A period of higher for longer US interest rates looms. 

In the Euro area, the picture is different. Inflation is returning more convincingly to target and economic growth is beginning to slow. Policymakers made decidedly dovish comments after their April meeting, noting that “it would be appropriate to reduce the current level of monetary policy restriction” if inflation continues to converge to the 2 per cent target. Many analysts expect rate cuts as soon as June. 

In theory, this means a stronger dollar and a weaker euro. As the chart below shows, the euro has already lost almost 3 per cent against the dollar this year, and analysts at Bank of America think that a scenario of no Fed rate cuts in 2024 could push the EUR/USD exchange rate below 1.05. The analysts even see scope for euro-dollar parity if the Fed holds as the European Central Bank (ECB) mounts an aggressive rate cut programme, implying a further 6.5 per cent depreciation.

But exchange rate movements don’t happen in a vacuum, and economists are increasingly preoccupied by what a strong dollar would mean for rate-setters elsewhere. All else being equal, a stronger greenback means higher import prices, which create a headache for policymakers by increasing inflationary pressure. In theory, rate-setters in the Euro area (not to mention in the rest of the world) could find themselves forced to keep rates elevated to counteract the impacts of a resurgent dollar.

Yet Jack Allen-Reynolds at Capital Economics thinks that “movements in the exchange rate tend to have only a small impact on Eurozone inflation”. He anticipates that it would take a big move in the exchange rate to have a significant bearing on the pace of ECB cuts. Research published by the ECB in 2020 suggests that even a 10 per cent depreciation in the euro would add just 0.4 percentage points to inflation after a year. As a result, analysts at Capital Economics are not forecasting a big drop in the euro in 2024. 

Even so, Bank of America analysts warn that a flight to safety from geopolitical tensions and even the threat of further US rate hikes could help to propel EUR/USD below parity this year by strengthening the dollar further. At this juncture, further US tightening remains only a tail risk (chair Powell said that rate hikes were “unlikely” after the last meeting), but one worth looking out for.

What this means for UK investors 

All this means more for UK investors than you might expect. A weaker euro would be good for European exports, particularly for the ‘Granolas’ that are driving the Stoxx 600 and highly exposed to the US. Nevertheless, European markets dipped after the last Fed meeting upon suggestions that US rates would stay higher for longer. A stronger dollar is bad news for firms importing raw materials – especially commodities that are priced in the world’s reserve currency. 

You don’t need to be heavily invested in European markets to take note of these impacts. The table below highlights how widely spread geographical revenues are for many UK-listed firms. Around 15 per cent of FTSE 350 total revenue is generated in the EU, and these euro-denominated revenues will convert back to fewer pounds should the euro weaken further. Meanwhile, UK-listed US-facing firms stand to gain a revenue boost from a stronger dollar. The relative forcefulness of ECB and Fed monetary policy decisions might seem like minor stuff, but they have implications for UK shareholders, too.