The probability of the euro and U.S. dollar touching parity grows as the central banks of the Eurozone and the U.S. approach their respective monetary policy meetings in December. The European Central Bank (ECB) and the Federal Reserve are likely to adopt contrasting policies to achieve their respective target inflation rates.

In terms of trading volumes, the foreign exchange market remains the world's most active and the largest. According to Alex Cukierman, a change in policies "or an anticipation of such a change" may have an immediate impact on the exchange rates. The exchange rate movements are typically based on the relevant information provided in statements and press conferences released by the Fed and the ECB before its meetings. 

Exchange rates are influenced by supply and demand of currencies and the supply is controlled by the monetary policies of the central banks. Although factors like inflation, speculation, currency account deficits, terms of trade and economic situations can influence the exchange rates, a change in the country's monetary policies can have a direct, substantial effect on the euro/dollar rate.  

Currently, a dovish action by ECB and a hawkish stand by the Fed may bring the euro to par with the dollar, although this event could be short-lived.

'Dovish' Actions by European Central Bank

The ECB meeting on Dec. 3 in Frankfurt precedes the Fed meeting. On Oct. 22, the euro fell against the dollar to its lowest level in two months at the hint of quantitative easing by ECB president, Mario Draghi. The monetary stimulus speculation weighed down the euro as it fell more than 1.5% against the dollar. In contrast, the dollar strengthened hitting a three-week high against the euro after ECB provided hints to lower deposit rates below zero.

In its December meeting, if the ECB resorts to easing its monetary policy further, then it could mean more euros in the market (through massive bond buying). Eventually, the increased Euro supply will make the Euro currency cheaper. At the macro level, a weaker euro would mean imports for the Eurozone getting expensive, which will push the inflation rates upwards. Exports from the Eurozone will also experience a tailwind, resulting in trade surpluses.

In other words, in an ideal situation, a monetary stimulus by ECB should boost inflation to target levels. As the euro becomes less attractive, investors will start dumping the euro-denominated assets in hopes to get better returns in another stronger, more stable currency.

The euro touched a seven-month low against the dollar this week as investors evaluated the effect of Friday's terror attacks in Paris on the region's ailing economic health. A senior portfolio manager at Boston Private Wealth, Robert Pavlik told the Wall Street Journal, "The dollar should be rising, both in response to the terrorist concerns because investors are looking for safety and because of the potential for easing."

'Hawkish' decision by the Federal Reserve

Interest rate differentials between the Eurozone and the U.S. are an important influence on the countries' exchange rates. An increase in the Fed Funds rate pushes the euro-dollar rate down (dollar appreciation) and attracts foreign investments to the U.S. As 2016 approaches, a strong dollar and a Fed hike could put solid pressure on the foreign earnings, which may act as a drag on the economy.

Considered to be a strong indicator for tightening of monetary policy, a pending Fed rate hike seems more of a necessity than a need by the year end. Given the current economic situation and a good October jobs report, many economists think that a rate hike "makes sense."

According to the minutes of the Fed's meeting on Oct. 27-28, "Some participants thought that the conditions for beginning the policy normalization process had already been met. Most participants anticipated that, based on their assessment of the current economic situation and their outlook for economic activity, the labor market, and inflation, these conditions could well be met by the time of the next meeting."

The next meeting of the Fed is scheduled to be on Dec. 15-16.

 

 

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.