The value of a currency is determined by its comparison to another currency. In the current globalized world, it's no longer desirable for a currency to be too strong at all costs. What really matters is that its exchange rate may stay near an appropriate level, and thus help to achieve the commercial and financial goals of a country.
The U.S. dollar can be considered a major brand of its economy and even a symbol of national identity. In 1985, it has made a gigantic top due to the policies of Paul Volcker to halt the stagflation crisis of the 1970s by raising interest rates. However, how is it possible that the dollar is now worth half the value it had back then?
In addition, over the past 10 years the dollar has remained on average 35% lower than the euro (FXE).
Let's study the relationship between the euro and the dollar. In order to simplify, while getting closer to reality, I will consider Germany as the main force of the European Union and the euro as if it was its former currency (the Deutsche Mark).
Assuming that currencies are generally dependent from several economic fundamentals, let's compare the indicators that are variation drivers in the exchange rate between the euro and the dollar.
1. GDP annual growth rate
Charts courtesy of www.tradingeconomics.com
The difference between rates of economic growth is significant. A higher growth rate of the United States over Germany will attract a larger volume of foreign investment thus increasing demand for its currency that will likely appreciate. Thus, there may be potential upside here in favor of the dollar.
2. Inflation rate
The difference between interest rates is relevant. It's true that a lower inflation rate in Germany tends to trigger an appreciation in the value of the euro. However, it would be necessary that its exports became more competitive. Analyzing export of both countries on the charts below we can find this is not the case.
3. Interest Rates
This is one of the most important factors in determining the value of a currency as higher interest rates cause an appreciation.
The United States has registered higher interest rates than Germany over the last 10 years. This situation facilitates an appreciation of the dollar against the euro.
4. Government Debt
The US has a higher government debt to GDP than Germany (101.6% against 81%). Nevertheless, this situation would only cause a fall in the value of the dollar against the euro if markets feared the US would default on its debt. In that case, foreign investors would want to sell their holdings of US bonds. But it is highly unlikely that such a move could happen. In fact, the largest holders of Treasuries are countries like China, Japan and other developed countries that will have a strong interest in defending their investments while sustaining or increasing the value of the dollar.
One must remember that several countries value their currencies based on the dollar. Even with the weaknesses perceived by the dollar over time, it has managed to maintain its status as the world currency, and the most important commodities are traded in dollars.
Back in 1985, by the Plaza Accord, it was agreed that parties would correct the excessive overvaluation of the dollar. Backed by coordinated intervention of other four big economies (France, West Germany, Japan and the United Kingdom), the Federal Reserve eased policies and allowed the dollar to decline in relation to the Japanese yen and German Deutsche Mark. In fact, the US dollar has declined heavily for 3 years to reach a value of 85 in 1988 not far from current level of 80-81. I believe it was an excessive intervention since the subsequent devaluation was even larger than the previous overvaluation that was supposed to rectify.
Apart from Germany, the euro is the currency of 17 other European countries, some with obvious financial difficulties. For that reason alone it would be normal that the euro was lower against the dollar. Indeed, the eurozone has its own problems that are structural, and resulting from an aging population and growing difficulties of many of its member countries.
While Fed quantitative easing is negative for the U.S. dollar, the advent of Fed tapering may be a period of its gradual though slow increase in the near future.
Ultimately, the supply and demand will dictate the Euro to US Dollar exchange rate, but its current level seems inappropriate with regard to the fair value between the two currencies. For starters, I think 1.25-1.30 will be the path to the medium-long term.