US dollar weakness
The dollar has lost over 10% against the euro since the start of the year, mainly due to political uncertainties in the United States. Damien Petit, Head of Portfolio Management, offered some explanations in the 1 September edition of the Luxemburger Wort.
In our March update, we mentioned that there appeared to be limited potential for the US dollar to rise. Since then, the US dollar has not only stopped strengthening but has seen a severe correction against the main currencies of the country's trading partners. The effective exchange rate has corrected by around 7% since the beginning of January. The dollar has fallen by over 10% against the euro, a significant drop. There are several factors contributing to the dollar's decline, especially against the single currency.
Chaotic internal politics
First of all, America's internal political situation appears increasingly chaotic. Embroiled in various problems - suspicions of collusion with Russia during the electoral campaign, escalating war of words with North Korea, disastrous management of racial incidents in Charlottesville, departure of a number of senior members of the presidential team - President Trump is looking increasingly isolated, especially from the economic world. His current inability to get the pro-cyclical reforms that were promised during the electoral campaign adopted, particularly the overhaul of the tax structure and the massive infrastructure spending programme, are clearly a concern to the markets and weighing on the dollar.
Inflation struggling to pick up
Secondly, despite progress in the economic cycle, US inflation is struggling to pick up. Consumer prices, excluding energy and food, have come in below expectations in the last five months, with the sharp reduction in expectations for an interest rate rise contributing to the dollar's weakness. The minutes of the latest monetary policy meeting also mention the fears of some FOMC members of seeing the inflation rate stagnating below 2% for the foreseeable future, which would limit the Federal Reserve's capacity to tighten its monetary policy.
Dollar declining sharply against the euro
The dollar has had a particularly bad run against the euro. The euro has certainly benefited from the US political situation and weak price growth in America. But it has also benefited from two other positive effects. First, a reduction in political risk in Europe, especially after the election of President Macron, and secondly, a positive economic dynamic in the eurozone. In the last three quarters, average growth has exceeded 2% (quarter-on-quarter annualised), thanks to sustained domestic demand.
ECB set to modify its economic policy?
In this more buoyant economic context, ECB President Mario Draghi has said that the bank will "extend and even increase its debt purchases", considering that deflationary forces have been replaced by reflationary forces. These words have been interpreted as heralding a change in the ECB's monetary policy. A reduction in the bond-buying programme is also likely to be on the ECB's agenda in the autumn, with a probable effective implementation in early 2018. But there is little likelihood of a complete halt to the asset purchase programme in the short term. Is the euro likely to strengthen further against the dollar? It is very difficult to predict what will happen to currencies given the many factors that can influence them.
ECB seems afraid of the euro strengthening further
It is interesting to note that the ECB now seems to be afraid of the effects of a stronger euro on the economy. The single currency's momentum has tightened financial conditions. This is likely to contain inflation, which is still far from the eurozone's 2% target. On the other hand, in the USA, the Federal Reserve recently announced that it would start tapering the size of its balance sheet in the near future, thereby signalling further monetary policy tightening. An interest rate rise in December and the announcement of significant tax reforms could also help offset the dollar's decline. But this last option will necessitate a totally different political dynamic across the pond.