Exogenous factors could boost the euro
The euro recently reached a 33-month low against the US dollar, highlighting the single currency’s relative unattractiveness. European equities continue to underperform their US peers and there is still a wide gap between the US and Germany 10-year yield (the yield on the former was 1.63% on 12 February, on the latter -0.38%).The economic growth differential is also still supporting the US dollar: leading indicators in the euro area show limited upside in terms of economic activity whereas the US economy is still proving relatively resilient.
A change in sentiment towards the euro in the coming months seems unlikely to stem from domestic macro factors: European Central Bank policy is resolutely on hold for now and leading indicators are not pointing to a strong pickup in euro area economic activity. This means it is more likely for exogenous factors to play the part of catalyst.
The euro’s growing role in funding means the currency is increasingly sensitive to events outside the euro area, including in emerging markets. Nor can one cannot forget is the US dollar; a decline in the greenback would likely benefit the single currency, which is its only credible alternative. A rise in global risk aversion could potentially lift the euro through reduced funding needs and short covering. An increase in stock market volatility this year should also play in the euro’s favour, especially if the euro area stock market starts performing better than the US one.
Overall, we are sticking to our view that we will see a moderate appreciation of the euro relative to the US dollar in the coming months, mostly because we see more risk of a negative surprise in the US than in the euro area at a time of fundamental overvaluation of the US dollar and pessimism surrounding the euro. We have a 12-month forecast of USD1.16 per euro, compared with USD1.09 on 12 February.
As long as the US macro outlook deteriorates, the euro should benefit either through a narrowing interest rate differential between the euro area and the US or a reduction in the euro’s use as a global funding currency. But recent adjustments to our US macro outlooks suggest that while the destination has not changed, the path to euro strength has likely become a bit longer.
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