Market Analysis

The euro is currently trading at its highest level this year against the dollar, emerging as a notable victor amid recent global currency market fluctuations that have disrupted the strong dollar and halted the yen's persistent decline.

Having decisively surpassed the $1.10 mark, the euro's more than 2.5% gain in August positions it for its strongest monthly performance since November.

Traders, previously focused on the yen's unexpected surge following the Bank of Japan's surprise rate hike on July 31 and the broader dollar's decline due to growing expectations of U.S. interest rate cuts, are now turning their attention to the euro.

Historically, the $1.10 level has been challenging to break through, and just a few months ago, some analysts were predicting the euro might fall to parity. Now, it stands as the second-best performing major currency against the dollar this year, trailing only the pound sterling.

While future gains are anticipated to be modest, they are significant given that expectations for U.S. Federal Reserve rate cuts coincide with speculation that the European Central Bank (ECB) might have limited room for further easing due to persistent service-sector inflation.

"It's a story about rate differentials," said Volkmar Baur, a currency analyst at Commerzbank. "Inflation is declining on both sides of the Atlantic, but the Fed is expected to implement more aggressive cuts, which narrows the rate spreads and supports a stronger euro."

Market expectations suggest the ECB, which cut rates in June, could introduce at least two more 25 basis point reductions. In contrast, traders anticipate 94 basis points of Fed cuts over the remaining three meetings this year, likely consisting of three 25 basis point moves and possibly one larger cut. This represents a shift of about 30 basis points from early August, while ECB pricing has remained relatively stable.

This shift followed disappointing U.S. labor market data, which fueled recession fears and impacted stocks and bonds. Although markets have since stabilized, expectations for policy easing persist.

The euro's strength in August is notable, but it is not the only currency to appreciate against the dollar. However, for traders seeking a relatively stable FX bet, the euro presents fewer complications compared to other currencies. The yen remains volatile due to the unwinding of a large carry trade, the pound has risen less following a UK rate cut, and French political risks, which affected the euro in June, have subsided.

"We've seen some risks removed from the euro, such as the French election," said Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International. "It's now becoming a cleaner central bank story."

Looking ahead, the euro may find it challenging to extend its gains. It is trading at the upper end of recent ranges, and there is limited potential for rate differentials to further favor the euro, according to analysts.

Commerzbank forecasts the euro will hold at $1.11 by year-end, while ING expects it to rise to $1.12 in a month before retreating to $1.10, and BofA predicts $1.12 by year-end.

"My recommendation since the second quarter of 2023 has been to play the trading range—buy the euro at $1.05 and sell when it exceeds $1.10," said Mathieu Savary, chief European investment strategist at BCA Research.

For some, these might be the highest levels the euro can reach this year.

"These are the strongest levels for the euro you should expect between now and the end of the year," said Guy Stear, head of developed markets strategy at the Amundi Investment Institute, who believes the case for further ECB cuts is stronger than for the Fed.

A recent slowdown in euro zone economic growth and a significant drop in German investor sentiment in August could contribute to this view. Additionally, upcoming U.S. jobs data might reveal that July's weak report was merely a temporary blip.

Another factor to consider is the upcoming U.S. presidential election on November 5. Analysts suggest that if Republican candidate Donald Trump wins, his policies of higher tariffs and lower taxes could lead to increased inflation, tighter Fed policy, and a stronger dollar. Conversely, Rabobank's head of currency strategy, Jane Foley, noted that the euro's rise has coincided with Democratic Vice President Kamala Harris gaining ground in opinion polls. "What could really push the euro/dollar above $1.10 and sustain it there is a Harris victory combined with a U.S. economic slowdown," she said.

Paraphrasing text from "Reuters" all rights reserved by the original author.