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With the US Dollar Index trading at a multi-year high and the EURUSD currency pair now at parity, some question how much further the greenback can rise. We’ll consider the fundamental, technical and political factors that could shape the future direction of exchange rates.
Fundamental factors
Factors that could strengthen the Dollar
In the near term, the fundamental factors that pushed the EURUSD lower are likely to prevail, to the extent that these trends are self-reinforcing: higher economic growth in the US has enabled the Fed to tighten faster than the ECB, weakening the Euro and increasing imported inflation into the Eurozone. In turn, this stagflationary shock has made it harder for the ECB to raise rates aggressively, prompting further weakness in its currency.
A continued surge in energy prices would also spell more bad news for the Euro, to the extent that Europe imports most of its energy. The rise in energy prices has been so significant that Germany’s trade balance recently recorded its first trade deficit in three decades. Energy prices are notoriously volatile and hard to predict, however, the balance of risks is to the upside as we head into the winter season and the Eurozone’s terms of trade deteriorate further.
Some commentators have speculated that the Dollar will continue to strengthen until “something breaks”. This would manifest itself through a surge in the Dollar and collapse in the Euro, the British Pound and the Yen. This scenario may seem far fetched, but isn’t without precedent. In 1985, the world’s central banks came together to weaken the Dollar through the Plaza Accord, after the US Dollar Index surged to 164.72 points. For comparison, it sits around 110 points today.
Factors that could strengthen the Euro
Expectations about the future direction of interest rates in the United States and the Eurozone could affect the EURUSD in expected ways. For example, a slowdown in the US economy could prompt the Federal Reserve to reassess the pace of its rate hikes, and place greater emphasis on preserving employment. A slower pace of rate hikes in the United States would slow the Dollar’s advance and could trigger an unwinding of speculative positions.
Conversely, a faster pace of tightening in the Eurozone than is currently priced in could also support the Euro. The European Central Bank took the financial markets by surprise on September 8th 2022 when it announced a large 75 basis point increase in rates, and warned of more increases to come.
The recent introduction of government schemes aimed at capping energy prices, in Germany for example, could soften the economic slowdown, and allow the ECB to increase its benchmark deposit rate faster than most market participants expect. This could also support the Euro in the months ahead, in ways that few foresee.
Technical factors
Technical analysis, in the form of chart patterns, trendlines and lines of support and resistance can also provide insights into future changes in exchange rates.
By historical standards, EURUSD is now trading at 20-year lows. The currency pair last hit that level in December 2002. At the time, EURUSD was in an upward trend that started from a prior low reached in late 2000, following the dotcom crash, according to this chart by TradingView.com.
Technical analysis shows that there is remarkably little support around parity, beyond its symbolic importance. If EURUSD were to convincingly break below $1, some commentators suggest it could return to the $0.85 to $0.90 trading range it experienced between 2000 and 2002.
Political factors
In Italy, upcoming elections could bring to power a right-wing coalition led by the Brothers of Italy. At present, it is polling close to 50% compared to 30% for Letta and its left-wing allies. A victory of the right-wing coalition could trigger a widening of Italy’s spreads and weakness in the Euro, which explains why hedge funds have been building large bets against Italian debt according to the FT.com.
Some commentators worry about radicalisation in the USA. The upcoming midterm elections in October 2022 could prove to be a flashpoint, and a forerunner of things to come in the 2024 presidential elections. The US Dollar will struggle to maintain its role as a global reserve currency if the Democrats or the Republicans cannot agree on the outcome of fair and free elections.
Importantly, a resolution to the conflict in Ukraine could also bring about a significant fall in the US Dollar against other world currencies. At present, a resolution to the conflict appears nowhere in sight. However, circumstances may change in a year’s time, once war has taken its toll on all sides. A way out of the conflict would trigger a rally in the Euro that could underpin a new bull-run.
How to trade the EURUSD
If you have an interest in the foreign exchange market, you could open an account with one of many MT4 brokers. Open a short EURUSD position if you expect the Dollar to strengthen, or go long if you expect the Euro to continue its downward slide.
Alternatively, you could also trade the US Dollar Index, which measures the strength of the Dollar against a basket of world currencies. Open a long position in the Invesco DB US Dollar Index Bullish Fund (UUP) if you expect the Dollar to strengthen, or a long position in the Invesco DB US Dollar Index Bearish Fund (UDN) if you expect otherwise.
Last but not least, you could also trade gold if you have a view on the Dollar, as the price is inversely correlated with the Dollar over time. You could speculate on the price of gold through an exchange traded fund that owns physical gold (tGLD), or buy shares in gold mining companies, like Wheaton Precious Metals (WPM).
But no matter which course of action you choose, you should always be mindful that trading carries a high level of risk. Whilst current trends favour the US Dollar against the Euro, circumstances may change over the course of 2023 in unpredictable ways.
