The euro has rebounded since falling below par with the US dollar last September, helped by cooling energy prices, easing fears of a deep recession later this year, and an increasingly hawkish European central bank.
The euro has gained nearly 13 percent over the past three and a half months, and the euro’s rally to its current level near $1.08 has been helped by a broad-based decline in the dollar, which has fallen by about a tenth against a basket of six peers since touching a 20-year high in September.
Last year, the US Federal Reserve raised its main policy rate by 4.25 percentage points, the largest one-year increase in four decades. The widening interest rate gap with other economies drew investors to the US, driving up the dollar, just as a sharp rise in energy prices exacerbated by the war in Ukraine threatened economic turmoil in Europe, weakening the euro’s appeal.
However, both trends have somewhat reversed since then. “For several years, there was almost no alternative to the dollar. Now, capital is flowing home again” to economies outside the US as other attractive options emerge, said Andreas König, head of global forex at Amundi. Foreign money has poured into China since it reversed its strict anti-coronavirus policies late last year, for example, in a move that also encouraged leading economists to upgrade their forecasts for global growth. The dollar tends to rise in times of macroeconomic stress.
Europe’s prospects have also improved. Aided by warmer weather, natural gas prices in Europe have fallen since late August to levels last seen before Russia’s invasion of Ukraine, easing fears of a deep continent-wide recession in 2023.
At the same time, lower headline inflation across the Atlantic meant the Fed was able to slow the pace of its rate hikes, with a 0.5 percentage point increase in December breaking a streak of four consecutive moves of 0.75 percentage point. Despite the caution expressed by many central bank officials, markets expect the Fed to start cutting interest rates in the second half of the year.
Lower rates would “remove a significant advantage for the dollar,” Lee Hardman, currency analyst at MUFG, said, and he expects the ECB to raise interest rates to 3.25 percent from 2 percent by the middle of the year.
“Last year the Fed led the way with larger hikes compared to other central banks, but now, for the first time, the ECB is outperforming the Fed.”
He added that the wide divergence between Fed and ECB policy could help the euro rise to $1.12 by the start of 2024. However, the persistent threat of higher energy prices, which would hurt Europe’s terms of trade, means that Hardman remains “cautious about going too high for the euro compared to the dollar so far.”