As the euro's exchange rate hits its lowest level since early 2022, analysts warn that sharp fluctuations in the euro could become the next source of volatility in global markets, following the turbulence caused by the yen's fluctuations in August.
In November, the euro-dollar fell about 3.8% and is currently hovering near the critical point of parity, pressured by trade tariffs proposed by U.S. President-elect Trump, a sluggish eurozone economy, and escalating tensions from the Russia-Ukraine conflict. Meanwhile, expectations of U.S. economic growth have bolstered U.S. stock markets and pushed up the dollar.
However, investors and currency traders have divergent views on the next moves of the dollar, as the dollar is also susceptible to inflationary tariffs and rising government debt, factors that are shaking investor confidence in the U.S. market and economy.
Analysts say that if the euro falls further, this uncertainty could intensify, increasing the risk of unexpected currency volatility that could upset the so-called ‘Trump trade’ (which bets on a falling euro and rising U.S. stock markets).
Kit Juckes, head of foreign exchange strategy at Société Générale, said, ‘We will face volatility as people start to think: Will the euro-dollar fall below parity, or will it bounce back? At least we will see more two-way debates about the euro's direction; I don’t believe this extremely high cross-asset correlation can last.’
The market crash in August began with fluctuations in the yen-dollar exchange rate, catching short-sellers of the yen off guard and triggering a global market sell-off. Regulators have warned that when popular market narratives shift quickly, the market is susceptible to similar events due to high leverage in the system.
Juckes said, ‘If the euro-dollar falls to parity, we will have this kind of discussion again.’
The Trump trade has driven the correlation between U.S. assets and the euro.
spillover effects
The euro-dollar is the most actively traded currency pair globally, with rapid exchange rate changes potentially disrupting multinational corporations' earnings and affecting the growth and inflation outlooks of countries importing commodities and exporting dollar-denominated goods.
Themos Fiotakis, head of global foreign exchange strategy at Barclays, said, ‘The euro is a benchmark; if the euro falls further, it means trade-sensitive countries like South Korea and Switzerland may allow their currencies to depreciate to compete with eurozone exports.’
He added that the pound fell more than 2% against the dollar this month, hovering around 1.26, highly sensitive to the euro's movements.
After currency strategists noted that traders were flocking into options contracts, the market's sensitivity to the euro-dollar exchange rate also increased, as these options contracts combined bets on the cross-asset outcomes resulting from Trump’s policies, such as euro depreciation and rising U.S. stocks.
Fiotakis stated, ‘We see many people trying to invest bets on these outcomes, which could increase the correlation of currency movements with the broader market.’
The euro-dollar is one of the most traded currency pairs in the world.
UBS strategist Alvise Marino said investors are underestimating this risk.
The indicator measuring investor demand for hedging against short-term euro-dollar volatility is currently around 8%, well below the nearly 14% level when the euro-dollar last fell below parity in October 2022. Marino pointed out, ‘The actual volatility in the foreign exchange market could be very high, certainly higher than what the market is pricing in.’
He advises clients to hedge currency fluctuations through derivative contracts, which will pay off if euro volatility is high after a year.
The indicator measuring expected volatility of the euro is relatively mild.
divergent views
At the same time, long-term asset managers have serious disagreements about the future movements of the euro and the dollar, highlighting the tumultuous situation this currency pair may face in the coming months.
Willem Sels, global chief investment officer at HSBC Private Banking and Wealth Management, said, ‘We expect the euro-dollar to fall to 0.99 by mid-next year.’
However, Vincent Mortier, chief investment officer of Allianz, Europe’s largest asset management company, said that a rate cut by the European Central Bank could boost spending by eurozone businesses and consumers, pushing the euro-dollar exchange rate up to 1.16 by the end of 2025.
The eurozone's economic growth lags behind that of major global economies.
In the rapidly changing currency options market, traders' pricing late Tuesday showed a 56% probability that the euro-dollar will be above the current level of about 1.047 by the end of the year, although major banks like JPMorgan and Deutsche Bank have stated that if tariff commitments materialize, the euro-dollar could fall to parity.
Market bets on the European Central Bank cutting rates by 50 basis points next month, bringing rates down to 2.75%, have increased, leading to a weakening of the euro.
However, a popular market narrative is that Trump’s aggressive growth policies and import taxes will push up U.S. inflation and keep interest rates high and the dollar strong, a narrative that is beginning to be questioned.
Stephen Jen, CEO of Eurizon SJL Capital, said that to curb the White House's continued massive borrowing against the backdrop of $27 trillion in national debt to fund tax cuts, the U.S. may face a so-called ‘bond vigilante’ moment, which would attempt to push up debt costs.
He said that the tightening financial environment should help the U.S. economy achieve a soft landing and lower long-term interest rates, making the dollar overvalued.
Article reprinted from: Jin Ten Data