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Traders have increased their bets that the euro could fall back to parity with the dollar, as persistently high inflation and resilient growth in the United States raise expectations that the Federal Reserve will only begin cutting interest rates months after the European Central Bank.
Investors have been buying options that will pay out 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 more than 10 percent 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 fallen 3.5 percent against the dollar since the beginning of January. Parity would require an additional drop 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 quite confident that the ECB will start easing its rates in June,” said Francesco Pesole, currency strategist at ING.
The cost of betting on further euro weakness in the options market has “risen quite dramatically lately,” he added.
Signs of persistent inflation and resilient growth in the United States have led traders to reduce their bets on how quickly borrowing costs will fall in the world's largest economy. Traders are now pricing in fewer than two quarter-point interest rate cuts this year from the Federal Reserve, compared with expectations of more than six at the end of last year.
By contrast, in the eurozone the annual pace of inflation fell to 2.4 percent in March, close to the ECB's 2 percent target, while growth also remains comparatively slow. The IMF said on Tuesday that the U.S. economy was on track to grow 2.7 percent in 2024, more than triple the pace of the euro zone.
Fears of escalating conflict in the Middle East and the possible knock-on effect of higher oil prices have also triggered warnings of a hit to the common currency as Europe relies 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 caused by the large-scale Russian invasion of Ukraine and during a massive bull run. of the dollar.
“The US economy is not landing yet [weakening] and the risk of rising oil prices has increased. This has dramatically increased the risk of an even weaker euro-dollar, even peg,” said Athanasios Vamvakidis, global head of G10 currency 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 Iran's airstrikes against Israel last weekend had been so far “relatively moderate.”
Signs of escalation in the Middle East could also push the dollar higher, as investors typically gravitate toward the dollar's perceived safety in times of stress.
Deutsche Bank and JPMorgan have warned that the ECB may have 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 a new increase in inflation by raising the price of imported products.
But Jane Foley, head of currency strategy at Rabobank, said the ECB may not oppose a gradual weakening of the euro as it begins to focus “more on growth risks than inflation risks.”
A softer exchange rate could help exports, Foley said, and the boost to growth would be particularly welcome for countries in the region, such as France and Italy, that are struggling with rising government deficits.
