In the list of major trading currencies, only the British pound has been up against the euro since September 28, 2022 – the date on which the euro started to turn around. The main losers were the currencies of the dollar bloc and the Swedish krona, where the decline swung up into double digits. Not to mention the big losers, the Turkish lira (-40%) and the Russian ruble (-44%).
The significant rise in EMU yields was probably the main trigger for the euro recovery – after all, we were still in the red on ten-year Bunds at the beginning of March last year. Currently, ten-year Bunds are yielding 2.45%, but ten-year Italian government bonds are yielding 4.09%, almost 28 basis points above ten-year US yields. After the Fed interrupted its rate hike cycle in June and the market is now pricing in five rate cuts for the end of next year, the greenback has faced headwinds in the FX market, even though the Federal Open Market Committee, which is responsible for monetary policy, will take action again tomorrow and adjust the Fed Funds Target Rate upward (then for the last time) by 25 basis points.
In our view, however, there are several reasons why the dollar’s weakness should not last: On the one hand, many investors still regard the greenback as the best insurance against global recession risks. On the other hand, the U.S. equity markets, which have been able to defend their bastion of relative strength in the international context for years, are still attracting capital. Not least because growth has not collapsed in the first two quarters – despite aggressive interest rate hikes. Another positive is certainly that headline inflation has now retreated to 3% and there is still full employment, which is supporting consumption. Thus, the Fed, which tightened the monetary reins much earlier and more aggressively than the European Central Bank (ECB), has so far fulfilled its mandate for the overall economy better.
On the other hand, the dollar could continue to be weakened by the rampant debt in the U.S.A., which the currency market has not yet “discovered” as a burdening issue. The national debt here now amounts to approx. 31.5 trillion dollars and thus already more than 120%. Dollars and thus already more than 120% of the economic performance. In conjunction with the high U.S. trade and current account deficits, the currently supportive factors for the greenback should therefore not be overestimated.
Notwithstanding the dollar-positive influencing factors, the euro managed to break out of the intact sideways range ($1.05 to $1.11) to the upside. This movement was driven by hawkish comments from ECB council members, who, in view of high inflation, gave the go-ahead for a series of further interest rate hikes. While the comments immediately after the June Council meeting were still unanimously hawkish, now even hawks like Bundesbank chief Joachim Nagel and Dutch central bank chief Klaas Knot have recently softened their sharp wording somewhat. Knot even expressed that rate hikes beyond July were not safe, as further hikes could shift the balance of risks toward “too much.” Given the technical recession and the far from encouraging economic outlook for the second half of the year, the ECB may be inclined to row back a bit, or put more emphasis on the data dependence of its further action. Accordingly, economic pessimists assume that the interest rate and growth differential will not shift in favor of the euro zone or the euro in the short to medium term.
It must also be admitted that the “Roman risks” are by no means off the table, which is a burden for the single currency. In addition, Germany, the former economic engine, is increasingly degenerating into the sick man of Europe. One point that could jeopardize euro strength in the medium term is the positioning of investors. Speculative market participants are now very long against the single currency. This constellation could well result in downside potential for the euro. The Ukraine war, which has been raging for almost a year and a half, and a possible escalation at any time also cloud the positive outlook. Seasonally, on the other hand, the euro faces a historically strong period from mid-August. Overall, the overall situation is still relatively balanced at the moment. However, investors who are long the euro should keep their eyes open. In view of our euro-dollar currency forecast (1.10 by year-end), the fantasy of a further sustained euro recovery is very limited. If at all, we believe that a renewed overshooting in the direction of 1.13 is possible at best, even if purchasing power parity indicates that the common currency is undervalued against the dollar.
Source: Bankhaus Metzler, automatic translation
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