Euro’s rally has further to run, investment banks predict

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The euro’s biggest rally since 2017 has further to run, Wall Street banks are predicting, as a broad shift by global investors to hedge their US dollar exposure suggests the single currency will soon be driven above $1.20.

The euro has strengthened more than 12 per cent against the greenback already this year, as a mixture of renewed optimism about Eurozone growth and fears over US President Donald Trump’s agenda has created what European Central Bank chief Christine Lagarde called a “global euro moment”. It hit a four-year high above $1.19 earlier this month.

Big investment banks, including Goldman Sachs, JPMorgan and UBS, think the euro, which has since fallen back a little to $1.17, will cross the $1.20 threshold in the coming months as the US Federal Reserve continues to cut interest rates, reducing some of the benefit from holding dollar assets. 

A significant factor for the euro’s move higher has been a rush by investors to hedge their dollar exposure, through contracts that in effect are a bet on the euro against the dollar.

We had “just seen the tip of the iceberg” of global investors hedging their dollar exposure, said Peter Schaffrik, global macro strategist at RBC Capital Markets.

“That’s at the helm of the dollar weakness we’ve seen, and there’s more to come,” he added.

In particular, big pension funds in some countries are lifting their dollar hedging levels from a low base, analysts observe. Goldman Sachs expects the euro to hit $1.25 within the next 12 months. JPMorgan expects it to reach as high as $1.22 by March. UBS Investment Bank expects $1.23 before the end of this year.

On average, investment bank forecasters expect the single currency to breach the $1.20 level in the third quarter of next year, according to estimates collated by Bloomberg. This would pile pain on the region’s exporters and also test the ECB’s comfort with the appreciation of the currency.

The cost to European investors of hedging their dollar exposure is tied to US interest rates, which are expected to come down over the coming year, closing some of the gap with the ECB’s policy rate. Foreign exchange experts expect this to feed another burst of dollar hedging.

“As that interest rate differential closes . . . [hedging] potentially becomes more palatable to put in place,” said Jackie Bowie, head of the Europe, Middle East and Africa region at advisory firm Chatham Financial.

Europe’s exporters have already sounded the alarm over the hit to their profits from a strong euro and have warned that a prolonged rally would weigh on them more heavily.

The euro breaking above $1.20 would also raise questions for the ECB as to whether it should countenance cutting rates to restrain the currency, given the potential for downward pressure on inflation from euro strength.

The $1.20 level was still a “line in the sand” for ECB policymakers, said Tomasz Wieladek, chief European macro strategist at T Rowe Price. ECB rate-setter Luis de Guindos said in July that an exchange rate beyond that level would be “much more complicated”. 

But Dominic Bunning, head of G10 FX strategy at Nomura, said a slow grind higher in the exchange rate would be of less concern to policymakers, given that it could help offset inflationary pressures stemming from a rise in economic demand.

A bigger concern would be “if the euro was rising rapidly at a time when domestic demand was weakening, and therefore currency strength was exacerbating disinflationary tendencies”, Bunning added.

Some banks are pushing in the other direction: Citi sees euro-dollar hitting $1.10 over the next six to 12 months “on signs for a potential US reacceleration”.

Over the long term, others point to a broader diversification away from dollar assets, which could be expected to benefit the euro. Central banks intend to increase their euro allocations over the next couple of years, according to a survey published in June by think-tank OMFIF.

“Euro appreciation is a structural story, as reserve currency managers begin to pivot out of the US and the Fed cuts rates,” said Wieladek.