Talk of the euro touching parity with the dollar is returning as policymakers at the European Central Bank (ECB) look primed to deliver more interest-rate cuts this year than their US peers.
 
Lenders including Bank of America Corp (BofA) and Germany’s LBBW are wargaming a variety of tail risks and warn of euro weakness ahead if wagers on the differing pace of rate cuts at the ECB and the US Federal Reserve play out. Geoffrey Yu, a senior strategist at Bank of New York Mellon, says the euro could touch parity with the dollar this year and doesn’t rule out a cut by the ECB on Thursday. 

For now, none of the strategists polled by Bloomberg have a one-for-one forecast as their base-case scenario, which would require a slide of about 8% to levels last seen in the depths of Europe’s energy panic after Russia’s invasion of Ukraine. But few are prepared to ignore the possibility of such a decline after traders were caught out by the 2022 slump - especially when a potential Donald Trump presidency could herald inflation-stoking tax cuts and trade barriers.

“The dollar would just go through parity like a hot knife through butter” if the Fed holds rates while the ECB eases, said Moritz Kraemer, chief economist at LBBW. The bank forecasts the euro sliding to US$1.01 in 2025 - the most bearish forecast of those compiled by Bloomberg.

ECB officials led by president Christine Lagarde are expected to put in more work when they meet this week preparing markets for an initial cut on June 6 as price pressures in the region ease. Though they’ve pushed back forcefully against the notion that they want to keep in line with Fed chair Jerome Powell, they haven’t committed to what happens after the first step, arguing that economic data will decide.

For investors, the divergence between the US and European economies is stark. 

Last Friday, US payrolls data rose by the most in nearly a year and the unemployment rate dropped, pointing to a strong labour market that’s powering the economy. In the euro area, inflation is cooling faster than forecast while the economy is almost no bigger now than in the third quarter of 2022, when the ECB started lifting rates.

That parting of ways is on show in the money markets. While bets on easing in Europe have grown less aggressive in recent sessions as US yields rise, traders still envisage the ECB juicing the economy with around 85 basis points (bps) of rate reductions in 2024. That compares with about 60bps for the Fed. 

The expectations have already put pressure on the currency, with the euro down almost 2% this year at US$1.09.

Strategists led by Athanasios Vamvakidis at BofA are weighing scenarios where the euro returns to parity against the greenback if the Fed stands pat on rates this year and the ECB delivers three quarter-point cuts. The euro could even fall further if there’s a fresh energy shock, they said.  

Every extra cut the ECB delivers relative to the Fed can trigger a 1% move in the euro-dollar exchange rate, according to Samuel Zief, head of global FX strategy at JP Morgan Private Bank.  

So-called risk reversals - a barometer of market positioning and sentiment - are pointing to further losses this week. But other metrics suggest a big move isn’t in the cards after the ECB decision. 

Parity partisans

Though Lagarde and colleagues will be keen to underscore that they don’t take their lead on rates from the Fed, they’ll be wary of exacerbating any divergence that could add to the currency’s weakness and fan inflation in the region.

“I know they all talk about being independent of each other, but there’s obviously links between different central banks via the currency mechanism,” said Jamie Niven, senior portfolio manager at Candriam. “I think we would struggle to see, for example, the Fed cutting 50 basis points and the ECB cutting 100 basis points.”   

Options markets imply only about a 15% chance of a big enough drop in the euro to take it to parity from current levels over the next 12 months. Flows into options since the central bank’s meeting in March suggest low conviction that the euro could weaken much below the psychological support level of US$1.05.

“Euro-dollar parity partisans are back in vogue,” said Audrey Childe-Freeman, Bloomberg Intelligence’s chief G-10 currency strategist. “While we’re not among them, our expected range of US$1.10-1.15 and outlook for euro strength in 2024 badly needs US data to weaken, a tamer US inflation trend and some upturn in the euro-area economy.”
 

  - Bloomberg