The euro has bounced back since falling below parity with the US dollar last September, helped by cooling energy prices, receding fears of a deep recession later this year and an increasingly hawkish European Central Bank.
Up about 13 percent over the past three and a half months, the euro’s rise to its current level of near $1.08 has been helped by a wider retreat for the dollar, which has fallen about a tenth against six peers since touching a 20-year high in September.
The US Federal Reserve last year raised its key policy rate by 4.25 percentage points, the largest one-year increase in four decades. A widening interest rate gap with other economies is drawing investors to the US, boosting the dollar, just as rising energy prices as the war in Ukraine threatens economic unrest in Europe, adding to the euro’s appeal.
Both trends have reversed since then, however. “For many years, there was almost no alternative to the dollar,” said Andreas Koenig, global head of FX at Amundi. Foreign money has poured into China since it reversed its strict zero-Covid policy late last year, for example, a move that has also encouraged leading economists to upgrade their global growth forecasts. The dollar tends to strengthen in times of macroeconomic stress.
Europe’s outlook is also improving. Aided by warmer weather, European natural gas prices have fallen since late August to levels last recorded before Russia’s invasion of Ukraine, easing fears of a continent-wide recession by 2023.
At the same time, the headline inflation across the Atlantic meant that the Fed could slow the pace of raising rates, with a 0.5 percentage-point increase in December to break a run of four consecutive 0.75 percentage-point moves. Despite the caution expressed by many central bank officials, the market expects the Fed to start cutting rates in the second half of the year.
Lower rates would “remove a big advantage for the dollar”, said MUFG currency analyst Lee Hardman, who expects the ECB to raise rates to 3.25 percent from 2 percent in the middle of the year.
“The Fed last year led with a larger increase than other central banks, but now, for the first time, the European Central Bank ‘outpaces’ the Fed.”
Differences between Fed and ECB policies could help the euro rise to $1.12 by early 2024, he added. Even so, the lingering threat of higher energy prices, which will damage Europe’s terms of trade, means Hardman remains “wary of higher gung-ho prices for the euro relative to the dollar”.