60-20-20

While it is the dollar that is pushing the pair lower, the uncertainty of how it will evolve from here lies more in what happens in Europe. Much of it is brewing now.    

Another week, and now the third, of strong appreciation of the dollar. The USD Index, in which the euro has a 58% weight, is beginning to draw after the 4% rise in the last three weeks a sort of almost vertical upward parabola in which the rapid depreciation of the yen is also collaborating, with a weight in the index of 13.5%. 

Something like this should be enough to ensure that the remaining upward movement should be modest, or at least enough tension should build up for a drastic reversal to be possible. This type of situation almost always ends up like this, but to reach the peak, almost everything that is evaluated must be favourable to the continuation of the movement.  This is the point where those who think they are missing the party come in and join in. The end point. 

PRIMARY AND SECONDARY

Given the speed of accumulation of arguments and their reflection in the price, we must be getting closer and closer; but (there are always buts), we still do not know what is happening with Russian gas, nor how deep the recession it may induce in Europe, nor how serious the threat of fragmentation in the European bond market is, and therefore how the ECB will respond. They probably don't even know themselves, although they will no doubt have a main scenario with something along the lines of 60% likely, and at least two secondaries splitting the remaining 40%.

THE CONSEQUENCES OF EACH

Let's take a chance on the 60% scenario. Russia will not cut off gas altogether, so as not to shoot itself in the foot. It will cut enough during the summer so that European stocks for the winter are not as high as we would like them to be. That will keep prices high and Russia will sell less to us, but earn the same revenue.  As prices remain high, disposable income is lower, aggregate demand for goods and services falls, and comes closer to disposable supply. Thus, rates do not have to rise much in Europe, (up to 1.5-1.75%), the Americans, who have no energy supply problem, raise them more (3.5-4.0%), and when the recession, still postponed, is fully incorporated into expectations, the time will come to think about lowering them. Don't think that some people are not already thinking about this. Whoever has raised them the most will lower them the most, the recession is neither deep nor long and then the time for the euro should come.  In the meantime, even with no minor fluctuations, the floor may be at 0.96-0.98 dollars. 

It could well be the case that everything moves forward, -we give this 20%-, and if this is compatible with a euro/usd time below parity, which it is, and soon everything aligns in favour of the dollar, with no more arguments to put in our mouths, it could be a matter of not too long before the picture changes drastically and where now, with all the wind at our backs, only dollar bulls emerge, the situation mutates.  That may intensify its strength, but it would be shorter. Dangerous, but resolved sooner. 

Of course, the worst is also possible. It is the remaining 20%. The gas cut-off is complete, Europe enters a longer and deeper recession, inflation expectations spiral out of control, the European bond market fragments, and the dollar, despite its parabola, appreciates beyond even the most bullish forecasts.  Add social conflicts in emerging countries and a rising incidence of Covid. Then even at 0.90 we will fall short. 

AN ETERNITY

Unfortunately not. This is not a classic final capitulation move of the last phase of a movement. Those whose position is structurally short of dollars can only hope for relief from good defensive management, which can never last forever, but can be adaptive; or that the miracle materialises that the ECB, tired of seeing how the European news reports open their economic sections highlighting that the euro is sinking, will show its disagreement and this will serve as an excuse for the market to cover its long dollar positions and give the euro some breathing space. It will never be definitive and they will come back again, so they are all in the same boat, every time it depreciates a little, BAM!, they buy it. 

The breakdown of the parity relationship, something of very little real value, is nevertheless highly symbolic and serves as an excuse for many to revise their conceptions and for the media to open up their news. It is difficult to know how the general population interprets the event, but it is not going out on a limb to say that few will like it, and that they will see it as another symptom that things are getting worse. 

That the dollar appreciates in this way always has beneficiaries, but on balance, many more will be hurt. By far. Rarely is it so obvious.   The negative consequences of a dollar in its current state, and more for its velocity and volatility than for the level itself, extend to many areas and globally. The strength of the dollar is not a stabilising factor, on the contrary. It harms world trade, hinders capital movements between countries, increases pressure on emerging economies indebted in dollars, becomes a cause of higher inflation and acts as a restraining factor in financial conditions. A strong dollar is bad news for the global economy. 

That should be enough that sooner rather than later, the consequences and the threat of further appreciation should lead central banks to try to draw a red line. History is full of such episodes. But the circumstances are now extreme, bets on a strong dollar in 2022 were non-existent in practice, meaning that portfolios are not oversupplied with dollars, and the recent monetary tightening and long financial repression make it advisable to hold cash, and in what currency better than the dollar? 

The dollar's only real shadow is the euro. For better and for worse. If the escalation could be halted, many emerging markets would breathe easier. So would commodity buyers, but as commodities are depreciating..., the urgency is less urgent. Not for the emerging countries, whose capital balances are heavily burdened by dollar-denominated debt, which is becoming more and more expensive, both because of the burden of rising interest rates and because of the exchange rate that increases the debt base.  Nothing good comes out of all this, but if little can be done, the less said about it, the better. 

That is why it is very unlikely that really important voices will be raised. For dollar shorts, the "dark side" is still ahead and they have to prepare for a difficult summer.  And if reading the forecasts can offer some consolation, because they do not abandon their modest bias in favour of the euro 6-12 months ahead, in the world we live in, it is better to be disbelieving. 

One semester is an eternity.