The Euro Strikes Back

By Ugo Lancioni

The currency has already priced in the recent good news.

The dollar was a reliable risk-off hedge in 2022 as skyrocketing inflation pushed bond/stock correlations further into positive territory. In a frantic need for diversification, investors unsurprisingly jumped on what seemed to be an unstoppable trend.

Even though long-term valuation metrics had been flashing U.S. dollar overshoot warnings for some time, taking a contrarian view by buying euros was far from straightforward: When gas prices jumped 300% in less than three months during the summer, the prospects of a deep European recession became a major cause of concern; Federal Reserve tightening pushed three-month FX forward yield differentials to 3.3%, making short dollar positions extremely expensive; and elevated global uncertainty made the U.S. a favorite destination for capital.

The euro/U.S. dollar exchange rate dropped to its lowest level at 0.9536 in September, but it has rallied since then. Why?

The very same drivers that caused the dollar to overshoot in 2022 are now forcing investors to chase the trend in the opposite direction. Stretched positioning helped the euro's rebound well before people could feel confident about an improving macro picture.

A mild winter helped European gas prices to get back below pre-war levels. Pessimism faded as European economic data surprised on the upside, triggering upward growth revisions for 2023. And despite uncertainty, the China reopening narrative boosted sentiment. Meanwhile, the view that the U.S. was insulated from global turmoil seems to have passed as its economy is slowing.

The recent outperformance of euro-denominated assets suggests that capital is flowing back to Europe. Meanwhile, the U.S. has seen record growth in its external liabilities, which have doubled over five years, reaching $16 trillion. Unwinding risk seems to be back on the radar screen.

The U.S. terminal rate is in sight and the market expects the Federal Reserve to cut rates later this year. In Europe, real rates are still negative, and the European Central Bank intends to tighten further. Another 110 basis points of hikes are expected in the next 12 months. Two-year U.S.-European Union rate differentials are back where they were a year ago at about 1.3%, helping the euro recovery.

At 1.09 versus the dollar, the euro has appreciated 14% from its lows. In our view, recent good news is already baked into the price. Long term, the U.S. dollar may have further room to depreciate, but for now, we would be cautious in chasing the euro higher unless the European fundamental picture further improves.

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