The euro hit parity with the dollar then slid again. Niall Dunneexamines a tempestuous relationship

The euro rallied to reach parity with the dollar for the first time in over two years on July 15th. The euro's 17 per cent rise, from $0.87 in March to $1.01 in July, was spectacular, and warmly welcomed by the EU and the European Central Bank, who have long protested that the single currency was undervalued by the market. Yet since July, parity has proved elusive for the euro, and forecasters who called for levels of $1.10 or $1.17 by year-end are busily revising their estimates. So where can we expect to go from here? Can parity be regained? Has the euro established a new trading range with the dollar? Or can we expect the dollar to weaken further?

From the start of the year, I have called for a stronger euro. And I hold with that call. Yet the rapidity of the euro's recent rally worried me. Purchase power parity always suggested the euro was undervalued, and called for a gradual appreciation. But what the market got was accelerated dollar devaluation brought about by factors external to the currency markets - led by corporate governance and accountancy scandals in the US.

This is why the euro was unable to hold parity in July. The psychology of the market is simple: it behaves as a crowd. When the scandals broke, the market scented blood, and took a one-way bet on the euro, with one aim in mind: parity. The market then sought further reasons to justify its gamble against the dollar, and found the reasons euro bulls have been pointing to all year: a dangerously expanding American trade imbalance, a substantial US Federal Government deficit, the potential cost of military action in Iraq, interventionist tariffs, overvalued equity markets and the threat of further corporate scandals.

So the euro broke parity, on the back of a speculative wave, and then investors cashed in their chips. As a result, we've seen the euro trade back to the $0.96-$0.98 range. But this does not represent a new trading range for the euro but only a period of consolidation.

Speculators justified their support of the euro based on the problems listed above, none of which has gone away. The US Treasury still maintains a "strong dollar policy"and the dollar is now so overvalued, tariffs are necessary to ensure the survival of certain US industries (most notably steel). The dollar needs to weaken to support US industry. The trade imbalance between the US and the rest of the world now runs at more than $37 billion per month, approaching 5 per cent of US GDP. Other currencies have collapsed at those levels. The dollar must weaken to reduce this deficit, to encourage US consumers to buy US produced goods, rather than cheaper imports. Otherwise the deficit can only be stabilised if foreign investors buy more than $2 billion of US assets every day - and thanks to recent events, our appetite for US assets appears to have been sated.

The US Federal Government is spending money it doesn't have - implementing excessive tax cuts to kick-start an economy where the consumer is rapidly losing confidence. Military action in Iraq is under consideration although this could cost $100 billion which the US economy cannot afford. Such spending worries the market and will weigh on the dollar.

Finally, professional investors still fear more scandal in Corporate America. The recent SEC deadline may have given some peace of mind, but it is not all that reassuring: it offered chief executives a get-out-of-jail-free card, by asking them only to attest their accounts were accurate "to the best of their knowledge". And by many historical measures, the broad US market is still overvalued. If demand for equities remains depressed, so will the dollar.

All these factors point to further dollar declines. But we will not see $1.10, or $1.17. The euro will strengthen as the market recognises the severity of the dollar's problems. Yet the market also knows the US is the engine of the global economy - and it knows if that engine stalls due to falling confidence, then all other economies will slow with it. Internal demand within the euro zone is insufficient to see Europe survive unscathed a US-led downturn. The US is the euro zone's largest export market, so euro zone growth forecasts will be marked down accordingly. I expect parity will be seen again late in the third quarter, with a year-end exchange rate of $1.03.

Europe will have its problems but the fact is the dollar is overvalued. When the market returns to normal after the summer, it will realise this, but its enthusiasm for the euro will be tempered by a realisation that euro zone growth prospects are linked to those of the US.

Niall Dunne is Ulster Bank Financial Markets Economist