After the ECB’s latest interest rate hike, the euro has risen to its highest level in over a month. How does the currency benefit from rising interest rates? And what role do economic expectations play?
The interest rate decision by the European Central Bank (ECB) has pushed the euro to its highest level in over a month. The European common currency climbed to $1.0949 in late trade yesterday. Today it remains above the $1.09 mark.
At the end of September, the euro had slipped to a 20-year low of $0.9538. But since then it has experienced a renaissance. By the end of last year alone, the currency was up more than 12 percent, and in early May it was $1.1068, its highest level since March 2022. What are the reasons? And which forces generally affect the development of a motto?
Business cycle, monetary policy and inflation decisive
“Basically, the currency of an economic area that is doing well is stronger,” explains Sonja Marten, foreign exchange expert at DZ Bank, in an interview with tagesschau.de. It’s like a share: stocks of a company that earns a lot of money are successful. “When money comes into the country and investments are made, the demand for the respective currency increases.” Therefore, expectations about the economy play a central role.
According to Euro Marten, worries about the energy supply in the winter had put a disproportionate burden on them in the autumn. When it turned out that the situation was not going to be as bad as feared, the economic outlook brightened somewhat and the euro exchange rate stabilized. In the spring it was finally weaker again because the economic data from the euro zone had surprised negatively, according to Marten.
Other factors that influence currency exchange rates are inflation and the monetary policy of central banks. “If I get higher interest rates on an investment, I get more money for it and it becomes more worthwhile,” explains Commerzbank analyst Esther Reichelt tagesschau.de. International investors rely on euros for investments in Europe, which increases demand for the currency.
Exchange rate is crucial
The ECB raised interest rates by 0.25 percentage points yesterday – the eighth increase in a row. In addition, the currency watchdogs in the euro zone signaled further hikes. “We haven’t reached our goal yet,” said ECB President Christine Lagarde, referring to continued high inflation. So will the euro rate continue to rise? “Whether interest rate increases have a positive or negative effect on the euro depends on whether they compensate for the loss in value caused by inflation,” emphasizes currency expert Reichelt. A high price increase ensures that the currency loses value and the investments accordingly become less attractive.
In addition, the course is always influenced by comparison with another currency and thus by the exchange rate. When the dollar falls, the euro trades higher and vice versa. This is also an important aspect for the upswing of the euro, according to Reichelt. “Since the fall, there has been increasing speculation that the US Federal Reserve will soon end its rate hike cycle.” The currency watchdogs of the ECB, on the other hand, had shown themselves more determined at the time to fight inflation with interest rate hikes.
As a rule, the euro benefits from rising interest rates, agrees Marten. “However, if inflation persists and the ECB is forced to keep raising interest rates at the expense of the economy, things can go the other way at some point.” While that doesn’t happen often, there is definitely a “tipping point” at which higher interest rates can have a negative impact on foreign exchange.
What’s next?
“We have a forecast of 1.12 dollars for the euro at the end of the year,” reports Marten. After Europe’s economy was rather disappointing and the US economy surprised on the upside, the economists at DZ Bank are expecting a reversal soon: “They assume that the USA will slide into a recession due to the aggressive interest rate hikes.” The Fed must cool down the overheated labor market and will accept a downturn to do so. This weakens the dollar and in turn strengthens the euro. The 12-month target in the forecast is $1.15.
“Our economists expect that the ECB and the Fed will soon end their interest rate hike cycle in lockstep,” says Commerzbank analyst Reichelt. For the time being, therefore, there would be no new impetus from monetary policy – whether upwards or downwards. In the medium term, however, the picture looks different. “Because the US Federal Reserve should not only achieve an inflation target, but also full employment, it seems justified to lower interest rates again more quickly when the economy cools down,” said the expert. In the euro area, that will probably not happen so quickly, since the ECB only wants to achieve its inflation target of two percent.
As soon as the market relies on this divergence of the central banks and prices them in, Reichelt believes that it will presumably trade the euro more strongly. When that will happen is difficult to say. “Since the market usually looks ahead in about half a year, we are already slowly seeing the appreciation of the euro.” Commerzbank forecasts the level of the euro at the end of the year at around 1.14 dollars.
consequences for the competitiveness one National economy
The consequences of exchange rate changes in a currency on the real economy are manifold. To categorize a motto as strong or weak is not always clear, says Marten. “Both have advantages and disadvantages – for example in terms of competitiveness.”
A weak euro can contribute to so-called imported inflation, since companies have to pay high prices for goods from other European countries and pass these on to consumers. At the same time, the German economy, which depends on exports, can benefit because products abroad are becoming cheaper and demand is increasing accordingly.
On the other hand, a strong euro can ensure growing prosperity through cheap imports and falling inflation. However, if the common currency is too strong, this puts a strain on competitiveness because it makes products more expensive in international comparison.