Investors in Europe are more optimistic than in previous years, thanks to a strong economy and optimistic market conditions. However, there is growing concern that the weakness of the US dollar could lead to a strengthening of the euro, and this threatens negative consequences for corporate income and economic growth.
Indeed, why is the dollar falling so much and how long will it last? Equally important, what are the consequences of a strengthening euro for Europe.
Cold Currency War
A 10% fall in the dollar against other major currencies in 2017 and a comment on January 24 by US Treasury Secretary Stephen Mnuchin at the World Economic Forum in Davos that a weak dollar is favorable for the US in the short term, they say anything but that the US administration is in the cold currency war and is winning.
Cold wars are not held in open combat (for example, with currency intervention), but through words and covert actions. The words in the Cold Currency War are loud and clear, but what are hidden actions?
Here is a combination of recent activities:
- fiscal expansion at the wrong time in the business cycle, financed mainly by additional Treasury debt;
The Fed, which does not seem to be willing to respond to monetary tightening beyond what has already been planned, is also discussing excess inflation.
These actions send, albeit a hidden, but very clear signal to the markets: the goal is a weak dollar. And the markets received this signal.
The reason the United States prevailed in this Cold Currency War is because the forces are unequal. US President Donald Trump applies the “big baton” policy: the threat of protectionism.
And therefore, Europe and Japan are forced to agree. This did not lead to the growth of their currencies either through words or through actions.
On the contrary, the ECB and the Bank of Japan have reduced the pace of their bond purchases. The ECB even hinted at a halt to net purchases later this year.
How long will it last?
The weak dynamics of the dollar could persist for some time, since the incentives for the main characters in the Cold Currency War have not changed.
The U.S. trade deficit widened last year, and fiscal expansion is likely to attract additional imports this year, so the Trump administration is likely to continue to be interested in weakening the dollar until it drops the bond market.
Moreover, by setting trading tariffs for the import of washing machines and solar panels on January 22, the Trump administration showed its willingness to use protectionist weapons.
Thus, one can hardly expect resistance to the “weak dollar policy” from Europe or Japan.
Although ECB President Mario Draghi expressed concern about “currency volatility” and “language use” at a January 25 press conference, the ECB is unlikely to resist more aggressively.
Perhaps this is a ray of light for Europe
A further significant appreciation of the euro will carry with it the risks of declining corporate profits, economic growth and the ECB's ability to bring inflation closer to the 2% target.
However, given that good times for the European economy may not last long, a stronger euro may serve as a catalyst for political changes that will affect a number of structural and institutional weaknesses in Europe.
As soon as a new coalition government is formed in Germany (which is likely to happen in March), the discussion between European governments on further steps regarding the banking union, in particular joint deposit insurance and further fiscal integration, will become more intense.
The proposals of French President Emmanuel Macron for further integration met a surprisingly positive response from the German parties SDP, CDU and CSU, which could form a coalition.
Of course, the devil is hiding in the details, and progress in creating a genuine banking union and joint budgetary potential to deal with adverse shocks is yet to come.
Here, much will also depend on getting rid of "bad" debts and reducing sovereign risk on the balance sheets of banks.
Nevertheless, nothing compels the gathering better than the impending threat, and strong further growth of the euro may serve this purpose. The US wins the Cold Currency War, but if Europe behaves correctly, it can be a winner.