Written by 11:24 am abroaden weekly insights

WTF x AWI #098 – It’s Parity Time!

parity fingers

This is issue #098 of our weekly newsletter where we’re covering exchange rate parity.

The euro and US dollar are almost equal. This parity will have far-reaching impacts for: 

  • Expats and others living abroad wanting to invest in their long-term future
  • International remote workers who earn dollars but live with euros
  • investors of all stripes

Since we’re in largely uncharted waters, we wanted to give you everything you need to know about what’s going on with the exchange rate so you can make better money decisions today and beyond. 

Before jumping in, let’s go through some quick terminology we’ll use.

  • FX rate: shorthand for “foreign exchange” rate. 
  • EUR USD: trader lingo to say 1 euro in US dollars. For example, 1.20 EUR USD would mean 1 EUR buys 1.20 USD. You can apply this syntax to any currency pair (NZDGBP, etc.). 
  • Parity: when exchange rates are equal; i.e., 1 EUR = 1 USD. 

Why is the exchange rate so close? 

Due to several factors, the EUR and USD are approaching each other for the first time in 20 years.

Inflation concerns and the reaction to them are making the dollar stronger.

Inflation levels are up to multi-decade highs in the US and Europe, mainly from the pandemic fallout and government efforts to prevent a depression. 

With the US economy running hot, the Federal Reserve, the US Central Bank, has already raised rates to cool off the economy and will do so again next month.

As interest rates go up in a currency, investors become more attracted to it as they can park their money there and get a higher return. 

Right now, the US dollar is looking more attractive by the day for people holding euros. That demand for dollars strengthens the USD.

A prolonged war in Ukraine raises concerns about Europe’s short-term economic prospects.

Since Russia decided to invade Ukraine in February, all economic hell broke loose. It’s no secret that Europe is overly-dependent on Russian fossil fuels — particularly oil and natural gas. 

As part of the economic retaliation against Russia for its naked aggression, Europe divested itself as much as it could against these hydrocarbons. 

Unfortunately, years of poor planning have left the continent with no immediate alternative supplier to Russia. Germany, in particular, is badly affected, with the government signaling that industrial production could halt this winter without sufficient reserves. 

The effect of sky-high gas and oil prices and food market pressures are driving European inflation, with little relief in sight. 

Bleak investor outlook towards Europe and the EUR

Energy and food issues aren’t the only problems for the eurozone. The last decade saw a prolonged financial crisis. Many southern European countries were on the verge of defaulting on debt and needing bailouts. While these economies are more robust than in 2014, they’re far from secure. 

With inflation relatively high here in Europe, the European Central Bank (ECB) should also raise interest rates. However, doing so might mean countries like Italy, Spain, or even France would have a harder time paying back their debt. 

This predicament means the ECB doesn’t have the same room as its American counterpart. 

All these combined are scaring investors away from Europe now, as many believe a recession is imminent. 

In turn, they’re leaving the euro for the dollar, which drives the exchange rate to parity.  

What does EUR USD parity mean for the economy, investors, American expats & remote workers living in Europe but making dollars? 

Parity, or the US dollar becoming stronger than the euro, will touch everyone’s lives. 

For the European economy

  • Imports will become more expensive. Global trade happens in USD. For us in Europe, that meant when we bought goods and services from abroad, we had a discount equal to the exchange rate. With that discount gone, we’ll be paying more in real terms for the same things. We’ll feel this in the gas pump and in the energy markets particularly hard. 
  • Inflation will go up. With our discount disappearing, prices will inflate to parity level with the USD. That’s not exactly good news for the ECB and the European economy, which are already grappling with high prices from the war and the pandemic fallout.
  • Exports get more competitive. On the flip side, European exports will get more competitive. Before parity, our products were relatively more expensive than those produced in USD. Now, we have a more level playing field between the two, which will help European exports offset some of the higher costs they see above.

For the American economy

  • Exports get less competitive, and companies will feel it. For Americans, they’ll see the inverse of their European counterparts as they’ll lose their built-in exchange rate discount. American companies with significant business in the eurozone will see their profits shrink.

    For example, we use Google Workspace here at abroaden and pay 12.00 EUR a month per user. When the exchange rate was 1.20 EUR USD, Alphabet (Google’s parent) would record revenue of 14.40 USD. Now, they can only make 12.00 USD which eats into their profit margins.
  • It will be cheaper to import from Europe. European exports will get more affordable for American importers. Europe produces a lot of advanced goods, which come with hefty price tags. Americans who buy them will pay less for the same products. Likewise, cheaper imports give less incentive to manufacture alternatives at home. 
  • Inflation in the US will go down. With lower profits and costs to import goods, US inflation should cool off. The US Federal Reserve would welcome this change as it will make their job easier. 

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What parity means for investors 

The economic impacts from parity will ripple through financial markets. On the one hand, European investors could cash out their early investments and get a slightly higher return thanks to the exchange rate. 

On the other hand, Europeans buying USD-denominated investments are getting less for their money. There’s also the risk of buying now at parity, only to see the exchange rate move back to a strong euro. 

Imagine for a minute that you buy shares in a company for 100 USD, which costs you 100 EUR. 

If the company goes up by 9% in the next six months, but the exchange rate goes back to 1.10 EUR USD, you’d wind up money. That’s because, on paper, you would have 109.00 USD, but in EUR, that would only be worth 99.09 EUR. 

The bigger problem is that US companies that sell in Europe will see their profit margins decrease. As we wrote above, the exchange rate gave American firms a booster profit margin. With that disappearing, they’ll report smaller earnings, hurting their share price. 

American investors are in an inverse situation where they could now put more money into European companies than before parity. They could also make a larger profit if the EUR returns to being the stronger currency. Even then, with dark clouds over Europe, the outlook isn’t exactly stellar. 

How remote workers earning euros & American expats in Europe will feel parity

People living in Europe but working remotely for US firms (or those invoicing in USD) will also benefit from parity. Mainly, your real income will increase as you get more EUR.

Of course, that also means you could owe more taxes if you accidentally wind up in a higher tax bracket. 

 You should definitely pay attention to how the strong dollar will impact your situation in that regard, as you probably don’t want a nasty surprise from the tax authorities next year.

Americans living and working and living in Europe will feel parity in a few different ways:

  • Your credit grows if you use the foreign earned income exclusion (FEIE) for your taxes. FEIE gives you 112,000 USD you can exclude this year in your taxes (and will likely go up a bit next year). With a weak dollar, your real exclusion rate was lower. With parity, you have more room to exclude. 
  • If you file with the Foreign Tax Credit, your credit will decrease. The foreign tax credit gives you credit for what you’ve paid locally to the taxman with the IRS before you pay Uncle Sam. Unfortunately, as the euro loses ground, that credit shrinks in dollar terms. That said, it’s not all bad news. Any income you have to pay tax for in the US is money you can put into your Roth IRA. 
  • Life will get cheaper for you (if you’re living off of your dollars). If you’re living off of your money in the US, congrats, we did it! You’re finally getting a better exchange rate, which will make life here in Europe (even) more affordable for you. 
  • Going back to the US will cost more if you’re earning EUR, though. We’re losing our discount when we go back home. As the US is a bit more expensive than many European countries, we’ll feel it when we go out or go shopping (although coupons are still as American as apple pie)

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