Recovering euro keeps dollar ‘gorilla’ from scuppering ECB rate outlook

The euro has resisted falling to parity with the dollar, thanks to a rosier economic backdrop, to the relief of European Central Bank (ECB) policymakers who could be struggling to detach themselves from the US Federal Reserve's monetary policy outlook.

A month ago the euro's fall to five-month lows prompted talk among analysts about a return to parity against the dollar as the fragility of the euro zone contrasted with a resilient US economy that boosted the dollar and prompted investors to dial back Federal Reserve rate cut bets.

Lower euro area interest rates than those in the US remain a headwind, but the euro seems on a stronger footing thanks in part to an improving macro backdrop.

The most recent round of purchasing manager surveys, for example, showed business activity in the euro zone expanded at a faster clip than that in the US in April for the first time in a year.

That has helped the euro recover roughly 1.7% from April's lows to around $1.0708 (R19.67).

"We’re starting to see that divergence between economic performance close, offering some help to the euro," said Fiona Cincotta, market strategist at City Index.

"That is also a cause for relief for the ECB and a reason for them to be more relaxed. It’s almost as if their ducks have lined up quite nicely so far."

Citi's economic surprise index for the euro zone has trended lower in recent weeks, but at 27 it is comfortably in positive territory as business activity and growth improve. In contrast, the US index has fallen below zero for the first time since early 2023 as crucial data such as growth and employment have missed expectations.

On a trade weighted basis, the euro is up 0.5% this year and not far from 2023's record highs. A lot of this is down to weakness in the Chinese yuan and Japanese yen.

That offers a less negative picture of the euro than purely looking through the lens of the dollar in that it neutralises some imported inflation.

A sustained drop in the euro could boost import prices and rekindle inflation, thereby limiting the ECB's scope to cut rates.

The euro has lost around 2.5% against the dollar this year and the ECB, which does not target an exchange rate, cannot easily ignore more weakness.

"To a certain extent, our data and decisions are naturally influenced by the Fed. We are not working in a vacuum. With the dollar the Fed is, figuratively speaking, the gorilla in the room," Austrian central bank Governor Robert Holzmann told Handelsblatt in an interview published on May 8.

Other factors such as a spike in the oil price or deterioration in geopolitical tensions could undermine the euro area by again hurting the growth outlook and magnifying the inflationary effect of a weaker currency.

Markets show traders believe the ECB will deliver three quarter-point cuts, bringing the benchmark rate to around 3.25% by year end. The Fed is expected to cut only twice, to a range of 4.75 to 5.25%, leaving the premium of US rates over euro zone ones at 175 basis points.

Some analysts think three cuts from the ECB and no cuts from the Fed this year, bringing the gap to 213 bps, might tip the euro back to parity, which could sound alarm bells at the ECB if currency weakness threatens to fuel inflation.

The euro last hit parity around August 2022, when the rate gap between the two central bank rates was 238 bps.

"If the market prices out Fed rate cuts for this year and pushes the cuts later into next year and the ECB pricing remains at the current levels, parity becomes a possibility and such a move would be enough to make the ECB delay its easing cycle," said Athanasios Vamvakidis, global head of G10 forex research at BofA.

Neil Mehta, a portfolio manager at BlueBay Asset Management, said the currency market was where the divergence in interest rates would play out most clearly, with the dollar emerging as the likely winner, with parity for the euro a possibility.

"It's not the base case, but we certainly see the risks tilted in that direction. We think the first step is $1.05 (R19.29)," he said.

Reuters