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EURUSD – The Road to Parity?

28 September 2020 By Mircea Vasiu

As we head into the last quarter of 2020, a year which has been like no other with the pandemic devastating the global economies. 

Central banks did the best they could under the circumstances. Together with governments, they eased the monetary and fiscal conditions in response to the most severe crisis humankind faced since the second world war.

One of the outcomes of all central banks doing the same thing (i.e., easing) was a lower USD. But if we look at how the market reacted right at the start of the pandemic, in March-April this year, we see that the initial reaction was to buy the USD. Only after the Fed intervened, the USD declined.

The Greenback’s Comeback

Two entities are worth watching in the United States. One is the Fed, and the other one the U.S. Treasury. When the Fed buys government bonds, it creates dollars out of thin air to pay for that debt. However if the Treasury (i.e., the one that issues the bonds) outpaces the Fed in the sense that it issues more debt than the Fed buys, the easing does not take place. Traders keep forgetting that all this time the Fed bought bonds, the Treasury issued even more debt and piled the USD.

Such a process led to USD being hoarded by the Treasury, but not being released in the economy. Hence, the easing is not real or, at least, not now. For this reason, at the first risk-off market move, we may see a USD reaction similar to the one seen in March-April.

On the other side of the ocean, the ECB faces low inflation. To fulfill its mandate, it must act, and this week’s HICP data is crucial. The previous release showed core inflation dropping to 0.4%, and projections for this week’s release range from -0.1% to 0.7%.

If inflation drops further, the ECB will not be here to stop the USD appreciation. In fact, just the opposite might happen, as the ECB introduced the exchange rate worries in its recent statement.

The EUR strength in April-May was much due to the Recovery Fund and hopes of a joint fiscal agenda. Now that the frenzy is over, the market will focus on what matters most – the ECB’s mandate and the fact that the USD liquidity, in fact, shrank all these months.

On any renewed USD strength, we should not be surprised to see the EURUSD making new lows. Some voices even call for parity sooner rather than later. With the second wave of infections already ravaging Europe and core inflation threatening to drop below zero, no one should be surprised by the EURUSD crossing the parity rubicund.

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