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Traders have increased their bets that the euro could fall back to parity with the dollar, as stubbornly high inflation and resilient growth in the United States raise hopes that the Federal Reserve will begin to reduce interest rate only a few months after the European Central Bank.
Investors buy options that will pay off if the common currency falls to $1 or less. Based on the pricing of these options, Bank of America strategists say markets are now pricing in a greater than 10% chance of such a scenario occurring within the next six months. At the beginning of January, the market saw virtually no chance of this happening.
The euro has already lost 3.5 percent against the greenback since the beginning of January. Parity would require a further cut of almost 6.5 percent.
“It now appears that markets have thrown in the towel on substantial rate cuts in the United States, while traders are almost certain that the ECB will start easing rates in June,” said Francesco Pesole, currency strategist at ING.
The cost of betting on further euro weakness in the options market has “increased quite dramatically in recent times”, he added.
Signs of stubborn inflation and resilient growth in the United States have led traders to reduce bets on how quickly borrowing costs will fall in the world’s largest economy. Traders now expect the Fed to cut interest rates by less than two quarters of a point this year, compared with more than six at the end of last year.
By contrast, in the euro zone, the annual pace of inflation fell to 2.4 percent in March, close to the ECB’s 2 percent target, while growth also remains relatively slow. The IMF said Tuesday that the U.S. economy is on track to grow 2.7% in 2024, more than triple the pace of the euro zone.
Fears of wider conflict in the Middle East and the potential fallout from rising oil prices have also triggered warnings of an impact on the common currency as Europe becomes dependent on energy imports.
The euro last fell to parity with the dollar in 2022, the first time in two decades, amid the energy price shock triggered by Russia’s large-scale invasion of Ukraine. Russia and during a huge rise in the dollar.
“The American economy still has not landed [weakening] and the risk of rising oil prices has increased. This has significantly increased the risk of an even lower or even equal Euro-dollar parity,” said Athanasios Vamvakidis, global head of G10 foreign exchange strategy at Bank of America.
ECB President Christine Lagarde told CNBC on Tuesday that the central bank would monitor oil prices “very closely,” but noted that the market reaction following Iranian airstrikes on Israel last weekend had been “relatively moderate” so far.
Signs of escalation in the Middle East could also push the greenback higher, with investors typically turning to the perceived safety of the dollar in times of stress.
Deutsche Bank and JPMorgan have warned that the ECB may need to act more gradually once it begins to reduce borrowing costs, as interest rate differentials could cause excessive weakness in the common currency and risk further surge in inflation by raising the price of imported products.
But Jane Foley, head of foreign exchange strategy at Rabobank, said the ECB may not object to a gradual weakening of the euro as it begins to focus “more on growth risks than on the risk of inflation.
A weaker exchange rate could support exports, Foley said, and the boost to growth would be particularly welcome for countries in the region, such as France and Italy, which are struggling with growing public deficits.
