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SourcePennpursuit32500reelGold ten data
Traders increased their bets that the euro could fall back to parity against the dollar as stubbornly high inflation and resilient growth in the US raised expectations that the Fed would start cutting interest rates a few months later than the ECB.
Investors have been buying options that will be rewarded if they fall to parity or below in Europe and the US. Based on the prices of these options, current market pricing suggests that there is a more than 10 per cent chance that this will happen in the next six months, according to BofA strategists. In early January, the market thought this was almost impossible.
The euro has fallen 3 per cent against the dollar since the beginning of JanuaryPennpursuit32500reel.5%. Reaching parity would require a further fall of about 6.5 per cent in Europe and the US.
Francesco Pesole, foreign exchange strategist at ING, said: "it now appears that the market has given up expectations of a big Fed rate cut and traders are quite sure that the ECB will start to ease policy in June." He added that the cost of betting on a further weakening of the euro in the options market had "risen sharply recently".
Signs of stubborn inflation and resilient economic growth in the US have led traders to sharply adjust their expectations for Fed interest rate cuts. They now expect the Fed to cut interest rates less than twice this year, only 25 basis points at a time.
By contrast, annual inflation in the eurozone fell to 2.4 per cent in March, close to the ECB's 2 per cent target, while economic growth remained relatively slow. The international monetary fund (IMF) said last Tuesday that the u.s. economy is expected to grow 2.7% in 2024, more than three times the rate of the euro zone.
Concerns about the widening conflict in the Middle East and the potential knock-on effects of rising oil prices have also triggered warnings that the euro will be hit because of Europe's dependence on energy imports.
The last time the euro fell to parity with the dollar was in 2022, when the conflict between Russia and Ukraine plunged Europe into an energy crisis and the dollar strengthened sharply. "the US economy has not yet landed and the risk of rising oil prices has increased," said Athanasios Vamvakidis, global head of foreign exchange strategy at Bank of America's Group of 10. This greatly increases the risk of further weakness of the euro against the dollar and may even fall to parity. "
ECB President Christine Lagarde said earlier that the central bank would monitor oil prices "very closely", but noted that the market reaction after Iran's air strike on Israel over the weekend had so far been "relatively mild".
Signs of an escalation in the Middle East could also push the dollar higher, as investors tend to think the dollar is safe in times of stress.
Deutsche Bank and JPMorgan Chase have warned that once the ECB starts to reduce borrowing costs, it may have to act more slowly because interest rate spreads could lead to excessive weakness in the euro and could push up the price of imports, causing inflation to soar again.
But Jane Foley, head of foreign exchange strategy at Rabobank, said the ECB might not object to a gradual weakening of the euro as it began to "focus more on growth risks than inflation risks". Foley said:
"A weaker exchange rate could help exports, and the boost to growth could be particularly welcome for countries such as France and Italy, which are grappling with rising government deficits in the region."