EUR/USD: are we on a path towards parity?

As we enter the last quarter of the year, a year unlike any other with the virus devastating the world's economies.

Central banks have done the best they can under these circumstances. Together with governments, they have eased monetary and fiscal conditions in response to the most serious crisis facing humanity since the mid-1940s.

One of the consequences of the joint action of central banks (i.e. the easing) was the fall of the USD. But if we look at how the market reacted at the beginning of the virus situation, we see that the first reaction was to buy the dollar. It was only after the Fed's intervention that the dollar fell.

The return of the USD

Two entities deserve to be monitored in the United States. One is the Fed, and the other is the US Treasury. When the Fed buys government bonds, it creates dollars from nothing to pay off that debt. However, if the Treasury (i.e., the issuer of the bonds) is ahead of the Fed in that it issues more debt than the Fed buys, there is no easing. Traders always forget that all this time the Fed has been buying bonds, the Treasury has been issuing more debt and stacking dollars.

Such a process led to the dollar being hoarded by the Treasury, but not released into the economy. As a result, the easing is not real, or at least not now. That is why, during the first risk reduction movement in the market, we could see a reaction of the dollar similar to the one observed in March-April.

On the other side of the ocean, the ECB is facing low inflation. To fulfill its mandate, it must act, and this week's HICP data is crucial. The previous release showed core inflation falling to 0.39%, and this week's release projects a range of -0.1% to 0.69%.

If inflation continues to fall, the ECB will not be there to stop the appreciation of the USD. In fact, quite the opposite could happen, as the ECB has introduced exchange rate concerns in its recent statement.

The strength of the euro in April-May was largely due to the Recovery Fund and hopes for a common fiscal programme. Now that the frenzy is over, the market will focus on what matters most - the ECB's mandate and the fact that the liquidity of the USD has actually declined during all these months.

If the dollar strengthens, we shouldn't be surprised to see the eurodollar pair hit new lows. Some voices are even calling for parity as soon as possible. With the second wave of infections already ravaging Europe and core inflation threatening to fall below zero, no one should be surprised when the pair reaches a parity threshold.