The Euro-Dollar Parity

It's a 1 on 1

On July 14, the European Union’s euro hit parity with America’s dollar, meaning the currencies converged into a 1:1 exchange rate. In addition to this occurring for the first time in 20 years, the currencies’ briefly-lived exchange rate is indicative of some pretty major macroeconomic effects on both the American and European economies. In other words, this is no small deal.

The euro is the official currency of the eurozone - a group of 19 out of the 27 European Union member states, collectively including nearly 350 million citizens. Regardless, a number of countries outside the eurozone still accept the euro either officially or unofficially; shops in Poland, the UK and Hungary all recognize it, for example. After their currency became effectively useless due to hyperinflation, the Zimbabwean government abandoned their ZWD and instead introduced global convertible currencies instead, including the euro. 

The euro is the world’s second largest reserve currency and the second most-traded currency, (behind the USD in both), with there being €1.3 trillion in circulation. So when the euro’s value relative to the dollar drops to a 2-decade low, people are gonna notice. 

To recognize the importance of this event, we must first understand why the parity occurred in the first place. One big contributor is the rapid interest rate hikes by the US Federal Reserve to combat record-high levels of inflation.

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Fed officials have made it quite clear that curbing inflation is a priority for them, meaning they essentially want to increase the dollar’s value as soon as possible - the lower the inflation, the greater value the dollar has. But what does this have to do with the euro? Think back to our article on the forex markets, where currencies themselves are assets that can appreciate and depreciate in value in terms of other currencies.

If the USD is likely to increase in value in the near future (which is really the entire point of raising interest rates to lower inflation), converting your money that’s held in say, euros, into dollars will effectively make you wealthier in terms of the euro. Suppose that the exchange rate between the USD and the EUR starts out as 1:1, meaning a person with 100 € can convert them into $100. 

Now say that a large number of people actually make that conversion and then the following day, the Fed goes crazy with interest rate hikes and the exchange ratio between USD and EUR changes to 0.5:1. Those people are now twice as wealthier in terms of euros because they put their money into an asset that doubled in value - the dollar. That’s what investors are hoping to do by dumping their euro funds into the USD. What this means is that because investor expectations are favoring the dollar, its value therefore increases since it’s now seen as the more attractive asset.  

This point can be further illustrated when comparing the US to other currencies such as Australian dollar, British pound, Chinese renminbi, Indian rupee and Japanese yen, all of which the USD has gained relative strength to. 

Conversely, the euro is being seen as a less attractive asset. With fears of an energy crisis as well as a recession triggered by the ongoing Russo-Ukraine war, it’s no surprise that people are beginning to lose confidence in the value that the euro will provide as a currency (energy crisis = rise in energy prices = inflation = depreciation in currency’s value). The demand for the euro drops, which then decreases its value. 

The other ramification of the war is that the cost of importing raw materials has also increased, since countries now have to turn to more costlier energy sources. This ultimately resulted in the bloc’s current account deficit being further widened. Exactly what that means is beyond the scope of this article, but the important thing to keep in mind is that this further weakens the euro.

So what does this parity mean for holders of these respective currencies? Europeans are obviously being hit the hardest since imported goods such as oil (which is priced in USD) now cost them more. On the other hand, a stronger dollar may not necessarily be in the interest of Americans; quoting from our article on the forex markets: 

The problem with continuing down this route for too long, however, is that as the currency appreciates, the country’s products become more expensive. 

If the USD grows too much in value relative to the EUR, European consumers may decide that American products are simply too costly, thereby decreasing American exports. In terms of policy, however, the parity has put the European Central Bank (ECB) in a less than ideal situation. There’s no doubt that the ECB and the Fed have been approaching things very differently when it comes to inflation, with the former advocating small and incremental hikes but the latter willing to risk a recession if it means cooling the economy. 

Analysts say that the ECB will have to gradually accept a more contractionary monetary policy in order to restore the euro’s ranking relative to the dollar, a task that may prove particularly difficult seeing as how the ECB has been comfortable with maintaining interest rates real low for long periods of time:

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Econ IRL 

All venture capitalists (VCs), regardless of their industry, face the same problem of having to predict whether a given startup will grow big. These predictions pretty much determine whether an entrepreneur will receive funding for their idea, and so it raises the question of how accurate these predictions really are. The author of this week’s paper seeks to provide an answer by putting together a dataset of over 16,000 startups and using that to train a machine learning algorithm which would then predict the success of a given startup.

Even though VCs had a nominal return of 79%, these gains are made mostly by the top half of investors - after dropping the bottom half of investments, nominal returns total to 41%. The author ultimately concludes that half of the investments were predictably bad - based on information known at the time of investment, the predicted return of the investment was less than other investment options. Why? The key bias could be the overweighting of human capital, meaning investors place too much emphasis on the characteristics of the founders rather than the underlying financials of the business. 

‘Till next time, 

SoBasically