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Currently, two reserve currencies dominate the global financial system; the US dollar and the euro. A reserve fiat currency must be freely convertible. Since fiat currencies derive their values from the full faith and credit of the governments that issue the legal tender, they must have a stable and robust economy and political system. Since the end of World War II, the US dollar has been the world’s reserve currency. Over the past two decades, the euro has also attained reserve currency status. Worldwide governments hold reserve currencies as savings and use them to settle cross-border transactions. The US dollar index primarily measures the value of the US currency against the euro as it has a 57.6% exposure to the European foreign exchange instrument. While the dollar and the euro could face a challenge from the Chinese yuan for reserve status over the coming months and years, the euro is the weaker link.
A long-term bearish trend in the euro versus the US dollar
The euro currency reached its high against the dollar in July 2008 when it took $1.6038 to buy one euro.
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The chart highlights the bearish trend of lower highs since 2008, leading the euro to its most recent low of $1.08063 in March 2022. At just below the $1.10 level on March 23, the euro currency was not far from the low with the levels of technical support at the recent low, $1.06362, the March 2020 low, and $1.03405, the January 2017 low.
Northern versus Southern European economies is a lagging and chronic issue
One of the primary reasons for weakness in Europe’s currency has been the approach of managing economies between northern and southern Europe. The southern countries have consistently needed bailouts from the northern countries. Austerity is an approach to economic management in Germany and other northern countries, while Greece, Italy, Spain, and Portugal have needed help to avoid defaults over the past years.
The 2020 global pandemic put pressure on countries throughout the EU. The United Kingdom’s departure from the European Union dealt a blow to the EU just as the pandemic gripped the economy. While the EU coordinated European policies, member countries remain culturally different. In early 2022, just as the impact of the pandemic was moving to the rearview mirror, Europe was hit with the worst crisis since World War II.
The euro has a geographical problem in 2022
Russia’s invasion of Ukraine caused the first major war in Europe since the 1940s. Russia never considered Ukraine a country, and President Putin referred to Ukraine as Western Russia. The US and its European NATO allies believe Ukraine is a sovereign Eastern European country.
As Ukraine moved closer to the west with the potential for NATO membership rising, Russia massed troops along the border. On February 4, President Putin shook hands with China’s President Xi on a $117 billion trade deal and a “no-limits” support agreement. While Russia intended to retake control of Ukraine, China seeks reunification with Taiwan.
The February 24 invasion created a brutal fight for Ukrainian independence on Europe’s doorstep. Western Ukraine borders on Poland, a NATO and EU member since 2004. If Russia’s incursion into Ukraine spreads to Poland, it will trigger NATO’s Article V, which states that an attack on one member is an attack on all members. The potential for a World War is now at the highest level since WWII, with ground zero in Europe. The geopolitical tensions and geographical location is weighing on the euro’s value in March 2022.
Russian expansion is bearish for the euro for three reasons
Ukraine is putting up far more of a fight than Russian President Putin believed possible, but that does not mean he is not prepared to use all means to return control to Moscow. Meanwhile, many other former Soviet satellite countries fear eventual Russian aggression as President Putin could seek to reassemble the former Soviet Union. The potential for Russian expansion is bearish for the euro currency for three reasons:
- Increased defense spending to defend bordering countries will cause economic hardship. Germany has already begun to increase its military spending dramatically.
- The refugee crisis will weigh on the European economy, with millions of Ukrainians already flooding into bordering countries.
- Russia supplies Europe with crude oil, natural gas, coal, other essential energy, metals, and agricultural commodities. Russia and Ukraine export one-third of the world’s annual wheat supplies and a substantial percentage of fertilizers. Rising commodity prices push inflation higher, weighing on the euro’s purchasing power as Europe is dependent on Russian exports. Sanctions on Russia will lead to retaliation that impacts European supplies of Russian raw materials.
The technical trend in the euro remains bearish in late March 2022, but the fundamentals caused by the war in Ukraine are likely to continue to push the euro lower over the coming months.
Parity against the US dollar is possible- FXE tracks the euro versus the dollar currency relationship
The only factor that may be holding the euro above parity against the US dollar is that inflation in the US is eroding the US currency’s purchasing power. The dollar and the euro are fiat currencies that derive their value from the fill faith and credit of the governments that issue the legal tender. Meanwhile, the dollar is the world’s reserve currency. While the euro is also a reserve currency, it is second to the dollar, and a war in Europe weighs on the euro’s value.
The long-term trend and geopolitical landscape are a potent bearish pair that is likely to push the euro’s value to parity against the dollar. The low in the euro versus the dollar currency relationship was in October 2000 at $0.8230. In the mid-1980s, before the EU and euro existed, the euro had an implied low of below $0.57 against the US currency.
The most direct route for a risk position in the euro versus the US dollar is via the over-the-counter foreign exchange market or the futures arena. The Euro Trust Currency Shares product (FXE) moves higher and lower with the euro’s value against the US dollar. At the $102 per share level, the FXE product had over $184 million in assets under management and traded an average of over 101,000 shares each day. The FXE charges a 0.40% management fee.
At the under the $1.10 level on March 23, the euro currency is literally teetering on the brink of a move to parity against the dollar. The bearish trend, decades of economic disunity within the EU, and a war in Eastern Europe with the potential to spread west is a highly bearish cocktail of technical and fundamental factors.