Edmund Shing
Hello and welcome to a new podcast from BNP Paribas Wealth Management. I'm Edmund Shing, Chief Investment Officer. Today, I’m joined by my Deputy Chief Investment Officer from Luxembourg, Guy Ertz. And today we are going to talk about currencies, in particular the euro-dollar exchange rate.
So as a backdrop, we have gradually and progressively changed our outlook to look for a weaker dollar after Liberation Day in mid-April, the time when President Trump announced hefty tariffs on countries around the world. We had initially all argued for a gradual rise in the euro to $1.15, and suggested there was more potential for that trend to continue over the coming quarters. After a further increase in the target to $1.20 in June, we now move again and expect the euro to rise to $1.24 over the coming year. So, Guy an obvious question: What are the reasons we expect even more weakness from the dollar than previously?
Guy Ertz
Well, the path of rates from central banks, in this case the ECB versus the US Fed. For the ECB, we have an unchanged outlook. We think that the ECB has finished its rate-cutting cycle with the deposit rate now at 2%, and 2% means really close to zero in terms of the real rate, the rate when you deduct the expected inflation. And we are looking for that rate level, 2% for the deposit rate, to be the level for the coming months.
For the Fed, we did change somewhat our view. We added one rate cut versus our previous outlook. Now why did we do that? I mean, the Fed is in a much more difficult position than the ECB. The ECB has the privilege that inflation is at target and the economy is gradually accelerating. And thus, having that zero real interest rate, the policy rate is quite comfortable and actually very easy to justify. For the Fed, it's much trickier because inflation remains high. It remains sticky above 3%, partially because of the tariff effects, and they are gradually coming in. So there are probably somewhat more to come into 2026.
On the other hand, because the Fed has a dual mandate, we have a deterioration on the job market for now. At this stage, it has not had a major impact on the unemployment rate. But the Fed has mentioned that they would put more emphasis on the unemployment component in that dual mandate and that they would also act in advance, anticipating the risk of further deterioration. So that opened the door for more rate cuts.
And that is the main reason, after the recent speeches that we have now included one more rate cut compared to the previous outlook. It means that we are basically looking for the end of the cycle, the so-called “terminal rate”, to be at 3.25% by mid next year, compared to 3.50% before. Now, what does that mean for the euro-dollar? Well, if we keep our view for the ECB unchanged, and if we add a rate cut in the Fed cycle, obviously that means that we should see a further shrinking of that interest rate premium that the dollar used to have. And thus, this will reduce the attractiveness of the dollar. So that is the major reason why we are increasing the euro-dollar target to 1.24, the target for the value of €1. That's the main rationale.
Edmund Shing
Okay. So as a complement to that, you've also been arguing, Guy, that the US dollar has seen an erosion of its safe-haven status. Now can you remind us what are the main factors behind this erosion?
Guy Ertz
Yes. I mean there are two main factors that we see. One is of course, the political pressure on the Fed. Now, at this stage, it's political pressure. We cannot talk about a loss of independence of the Fed, but it is a topic and it will be very key, especially next year, because we will have the replacement of Jerome Powell, the current chairman in spring 2026. And it is possible that we will see a further reshuffling, a further change, in the composition of the board of those Fed members that have voting rights. And that could be gradually shifting the opinion of the Fed towards a more dovish stance.
And the question, of course, is then to what extent will that stance become excessive compared to what is justified by economic fundamentals. And to what extent that can then be interpreted as a loss of independence? Why is that important? Well, if that is the case, it would obviously make investors nervous about the ability of the Fed to control inflation over time and to manage low volatility of inflation around that long-term target. And if that is the case, that could definitely, reduce further the perception of the dollar as a safe-haven currency, so that is going to be very important to monitor. And it is clearly a risk going forward.
The second dimension is the deterioration we've seen in terms of the debt dynamics in the US. We've seen rising deficit levels as a percentage of GDP. We have seen the debt ratio, the debt as a percentage of GDP rising. It is unlikely that this will decrease. I mean, the president is targeting some specific measures that will reduce the deficit. But at the same time, it's very likely that other measures will be increasing the deficit. So on a net-net basis, it is unlikely, that this worrying trend is going to reverse anytime soon. And at some point that could add to some hesitation of foreign investors to continue buying US assets at the same level as they used to.
Edmund Shing
Okay, so if you talk about long-term models of valuation for currencies, we typically talk about the issue of Purchasing Power Parity, which is the classic model used particularly for foreign exchange, i.e. currencies. Now, today, what does this PPP measure suggest for the longer-term equilibrium value of the dollar?
Guy Ertz
Yes, that's particularly interesting because of course, the question is not only how the euro-dollar will evolve over the next 6 to 12 months. It is really also where are we heading in the medium term? And as you mentioned here, over a period beyond 1 year and more, on a 2- or 3-year horizon, the PPP is often mentioned, of course, as a reference. It is the level of the euro-dollar that is actually bringing, to the same value, the two baskets of reference goods when you calculate them in the same currency. And at this stage, the OECD is estimating that kind of equilibrium long-term, fair value of the euro-dollar at 1.38, the value of 1 euro. So, a stronger euro than we see today and even stronger than our new target.
To what extent can we expect a convergence to such levels? Well, historically, we've seen deviations from that long-term fair value and deviations often for many years. As such, it is not really something we would expect to happen in the next few years. It is probably a very long-term process. However, there are interesting studies that tend to show that if the gap between today's euro-dollar and the fair value becomes quite large, then there are some arbitrage processes kicking in, and they tend to reduce the gap by half in about 1 to 1.5 years.
What does that mean in practice, reducing the gap by half? Well, with the current level around 1.17 and the target long-term fair value at 1.38, broadly speaking, it would mean converging to 1.27. So we have at this stage, our 12-month target at 1.24; 1.27 is probably a little longer term. But we see that if we reach our new target, 1.24, at some point in the coming year, the further upside then remains much smaller if we use that kind of fair value and this half-life concept. So that is really taking a step back a bit more in the longer term.
Edmund Shing
Okay. Great. Well, thank you very much for all that, Guy. And to everyone listening, please remember that all details of this change in forecast are available in our monthly FX Focus document, which is available on the BNP Paribas Wealth Markets Insights website.
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