Euro-dollar parity matters for UK investors, too

Big news last week as the euro and dollar reached parity, trading at a one-to-one rate. The last time this happened was over 20 years ago. And it marks a significant slide: this time last year, one euro would have got you almost $1.20. 

This parity is a function of a very strong dollar and a pretty weak euro. And there are three key drivers of this. The first is that interest rates in the US are still significantly higher than in the eurozone, with another substantial US hike likely next week. This has seen investors rush to lock in higher short-term interest rates, increasing demand for the dollar. 

The gloomy global economic climate is contributing to the dollar’s strength too. The dollar is traditionally a safe haven currency, whereas the euro tends to move more pro-cyclically – weakening as the economic outlook darkens. 

The eurozone also finds itself in a more precarious economic position. The eurozone economies are more vulnerable to rising energy prices than the US, especially given the risk of Russian threats to energy supplies. ING economists also note that the US entered its rate-hike cycle with more momentum and a positive output gap. The eurozone, on the other hand, is about to embark on its own tightening cycle with concerns about spiralling bond spreads and asymmetric impacts on member states. This combination of stronger growth and better energy resilience have made the dollar more attractive, fuelling an appreciation against the euro. 

All very interesting, but what does this mean for the UK? More than you might think. As the chart shows, the UK is playing piggy in the middle: weak against the dollar, but relatively strong against the euro. Even if your investments are heavily UK skewed, this matters. Firstly, companies importing in dollars will face higher prices: bad news, given already high raw material prices. It will, however, render euro denominated imports cheaper. Exporters trading in dollars will find themselves more competitive, whereas exports to the eurozone will become relatively expensive. 

It would also be a mistake to think of UK-listed companies as UK based: only 24 per cent of FTSE 350 total revenue is generated in the UK. Almost 15 per cent of revenue is generated in the EU, and the weak euro is bad news for these European-focused companies: euro-denominated revenues will convert back to fewer pounds. Yet the opposite is true for US- facing firms who can now convert dollar revenues into sterling at more favourable rates. 23 per cent of FTSE 350 revenue is generated in the US – almost as much as in the UK. UK investors with holdings aligned to world markets might also be more exposed to dollars than they think: the US stock market accounts for around 67 per cent of the MSCI World Index.

Euro-dollar parity also teaches us an important lesson about ‘psychological barriers’: key values used as entry or exit levels by investors. They are often set at whole numbers and we tend to see high levels of market activity when they are breached. ING’s global head of markets, Chris Turner, highlights that the dollar to Swiss franc exchange rate fell 5 per cent within a week of hitting parity in May and June. The euro-dollar exchange rate looks set for similar volatility as it bounces around parity: Turner forecasts that EUR/USD will trade at around 1.05 over the summer, but with a "highly volatile range".

Psychological barriers come into play elsewhere, too – a 2019 research paper found evidence of them in fledgling markets markets. The report argued that given the cryptocurrency market is inhabited by inexperienced investors, it is more susceptible to the decision-making biases usually associated with psychological price barriers. And they seem to have been proved right: much was made of Bitcoin dipping below its own psychological barrier of $20,000 last month. To an outside observer, sensational reports about marginal price changes can seem overblown. Psychological barriers might help to explain all the fuss.