After coming back from parity late last year, the Euro has been steadily rising for months. As it’s getting close to the technically significant 1.1000 handle, it’s worth having a look at the fundamentals. Is there enough drive to push through the resistance point, or will technicals be able to overcome fundamentals?
The main theme so far has been, “never bet against the central bank”. On the other hand, that doesn’t mean the central banks’ plans will actually work out. The currency pair has been driven by the two central banks dealing with essentially the same domestic problem: Inflation. But European inflation is different from US inflation, and the difference in policies from the two central banks has driven a rather large swing in the EURUSD.
Returning to the norm
For most of its existence, the Euro has been valued at more than the dollar, leaving the pair well above parity. The sudden drop in the Euro with respect to the dollar coincided with the Fed’s aggressive move higher in interest rates while the ECB waited several months to start hiking. Now that both central banks are talking about “normalization”, does that mean the pair is going to return to their “normal” level above parity?
There is still a little bit left for the central banks to do before they reach “normal” according to their own estimates. The Fed is expected to hike at least once more in this cycle. The ECB is talking about at least 50-75bps more of tightening. That means the gap between the interest rates of the respective economies that created the move lower in the Euro is expected to close a little bit more. That could help support a stronger Euro over the coming months.
Before we can get back to normal
That scenario supposes the central banks are right about their future predictions. Given their track record, including predicting “transitory inflation” just recently, betting on central bank forecasts seems just as foolhardy as betting against their policy. A “hard landing” recession, either coincident or provoked by higher interest rates, could significantly shake up this scenario.
The Fed has hiked substantially more than the ECB, meaning that it has more room to cut in the event of a recession. While this would be expected to weaken the dollar more, its status as the reserve currency and safe haven could keep it stronger than the shared currency. The other thing is that while there are quite a few forecasts of a recession in the US, the consensus on a “hard landing” in Europe is much less firm.
There needs to be a bubble for it to burst
The US has seen a strong post-pandemic rebound, with unemployment falling to and remaining near historic lows. Europe, on the other hand, has struggled to take off, has been limited by the energy disruptions from the war in Ukraine, and is largely seen hampered by regulations that make it hard for businesses to quickly adjust to changes in the economic situation. In other words, Europe has less of a distance to fall if it comes to a recession, implying the ECB can keep rates higher.
If inflation in the two economies flatten out, the ECB has reason to raise more than the Fed, implying a stronger Euro. If there is a dual recession, then the central banks could move in tandem, minimizing the impact on the currency pair. But a recession in the US and Europe avoiding a significant drop in GDP could give the EURUSD some strong impetus through the end of the year.
