Euro Optimism Growing as Europe Aims to Avoid Recession, Say Currency Experts

The euro has fallen below parity with the US dollar in recent months, but has recovered somewhat to trade at just above $1.07 on Wednesday morning.
The euro's weakness last year was largely due to the aggressive monetary policy tightening from the U.S. Federal Reserve, while the European Central Bank was much slower in hiking interest rates to contain inflation.

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However, recent data trends suggest that the European Central Bank may need to continue its hawkish stance, while the Federal Reserve may start to slow down its rate hikes. This would narrow the interest rate gap between the two regions, which would be positive for the euro.
The economic threat posed by sky-high energy prices in the euro zone has also faded amid an unseasonably mild winter in much of northern Europe. This has helped to ease concerns about inflationary pressures in the euro zone.

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Steve Englander, head of global G-10 FX research at Standard Chartered, said in a note Monday that the euro is trading within its late December range, but incoming data since the beginning of 2023 suggest that it should be stronger.
"Both euro area core inflation and economic surprises have continued to strengthen, making it easier for the European Central Bank to maintain a hawkish tone. Energy concerns that loomed large as a EUR-negative in mid-2022 are beginning to ebb."

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Annual headline inflation in the Euro zone slid to 9.2% in December from 10.1% in November, according to preliminary figures from Eurostat. However, core inflation, which excludes volatile energy, food, alcohol and tobacco prices, rose by more than expected to hit a new record high of 5.2%.
In recent weeks, both the ECB and the Fed have struck a hawkish tone as they focus on returning inflation to target. ECB policymaker Robert Holzmann told a conference on Wednesday that “policy interest rates will have to rise significantly further to reach levels that are sufficiently restrictive to ensure a timely return of inflation to the 2% medium-term target.”

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However, Englander pointed out that the data surprises in the U.S. have been “middling to weaker” than in Europe, indicating less upward pressure on rates. This is likely because the U.S. economy is further along in its recovery than Europe, and so it is not seeing the same level of improvement.
He noted that the average hourly earnings (AHE) trend in the latest release was much more mild than those the Federal Open Market Committee (FOMC) was working with in mid-December, when 6-month annualized earnings growth through November was 5.3% and increasing.

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According to Englander, the 6M annualised wage increase in December fell to 4.4%, and the December non-manufacturing ISM was the lowest since 2010, with the exception of when COVID hit in 2020. Fed Chairman Jerome Powell has repeatedly emphasized the importance of wages in bringing core services inflation down. He has pointed to wage growth as a risk factor in the Fed’s mission to reduce inflation.

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According to Englander, if productivity growth trends have not changed since pre-Covid, this would leave AHE growth consistent with 3-3.5% underlying inflation.
This is not an acute inflation problem, as wage growth is consistent with 3-3.5% inflation. However, if the wage trend continues to head lower, it could become a more serious issue.

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A reduction in core services inflation would give the Fed more space to cut its aggressive rate hiking cycle later in the year, and potentially even start to reverse it.
George Saravelos, Head of FX Research at Deutsche Bank, believes that the so-called "Fed pivot" could be the key to unlocking more sustained euro gains. This potential turning point for markets has been widely discussed in recent months and could provide the boost that the euro needs to move higher.
Saravelos said in a note Monday that the U.S. dollar "defied historical experience last year by overshooting relative to the prevailing growth, inflation and monetary policy mix."

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According to one analyst, the risks are shifting towards an earlier dollar drop than previously anticipated. They recommend buying EUR/USD and targeting 1.10 by Q2, with a year-end forecast of 1.15. Saravelos agreed with Englander's assessment that the relative policy cycles in the U.S. and the euro zone point to the Fed pivoting before the ECB. He said that this is due to the fact that the U.S. economy is currently in a stronger position than the euro zone.
"The latest PMI numbers in Europe show that there may not be a recession this winter," he said. "The unemployment rate is still declining and fiscal policy is structurally easy."

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The debt ceiling poses risks to U.S. fiscal policy this year, and the market is already pricing in the Fed's desired level of real rates. U.S. labor tightness metrics are turning faster than Europe, which could pose downside risks.
Saravelos said that after the global uncertainty of 2022, markets are sitting on large amounts of cash exposure to the US dollar. He suggested that this could be vulnerable to further liquidation given that two of the main drivers of the dollar's safe-haven appeal last year - Europe's energy shock and China's zero-Covid policy - have turned a corner.

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He argued that China's reopening could also provide a boost to the euro, since it is a pro-cyclical currency and "turning points over the last decade have coincided with a turn in the external growth cycle."

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"Tight monetary policy from central banks is a big drag on global growth, but China's shift away from its zero-Covid policy is a tailwind. This also helps to prevent upward pressure on the value of the US dollar against the Chinese yuan."