People wait at a currency exchange office as pedestrians walk at Omonia square in Athens, Greece, on July 13. The euro appears set for a comeback on the global exchanges only a few months after falling to parity with the US dollar for the first time in nearly 20 years. Photo: AP
Opinion
Macroscope
by David Brown
Macroscope
by David Brown
Oversold euro has better days ahead as US dollar strength starts to unwind
Global currency managers are reassessing their positions on the euro as sentiment turns against the US dollar and investors look for better currency bets
As sentiment improves, portfolio reweighting should add more momentum to the euro’s rally and create better times for Europe’s shared currency
The dominant US dollar will be a tough act to follow. The strong dollar trade continues to unravel as the US Federal Reserve winds down its aggressive interest rate campaign against inflation and investors ponder the possibility of an early US rate easing in 2023.
The quandary for investors now is choosing which is the best currency bet instead. Has all the bad news been factored into the euro, making it a prime time for investors to buy again? The European Central Bank (ECB) is still sabre-rattling over inflation, and the ultra-hawkish German Bundesbank finally seems to be getting its way in curbing excessive price rise risks.
US-euro government bond yield gaps are starting to narrow, most of the shock of the Ukraine war is already factored in and safe-haven US dollar demand is losing its appeal. Global currency managers will be reassessing the need for rotating overweight US dollar holdings into longer euro positions. Will 2023 be the year the euro comes back into favour?
The euro is already back on the road to recovery, bouncing back from a dip below parity versus the US dollar in September, subsequently rising 8 per cent as the rampant US currency has eased. The war in Ukraine has not helped euro perceptions since hostilities broke out in February, as investors have fretted over the risks of the conflict spilling over into the rest of Europe.
But with the war grinding to a winter stalemate and with suggestions of peace moves circulating, it’s no surprise investors believe the euro may be oversold and due for a sustained recovery in the coming months. But it has to be conditional on regional risks not flaring up again.
There is a growing sense that risk aversion is coming off the boil and market confidence is building up again. Stock markets remain in a reasonably bullish mood, with fear factor measures such as the CBOE volatility index moderating in recent weeks.
Women from Ukraine dressed up as angels collect donations for Ukrainian children at the Christmas market in front of Charlottenburg Palace in Berlin, Germany, on November 24. With the war grinding to a winter stalemate, investors are coming round to the idea that the euro may be due for a recovery in the coming months. Photo: Reuters
Government bond yields have started to ease and benchmark corporate spreads are converging as investors have begun pushing the boat out for trades with higher risk and higher return. Despite cooling economic conditions, it is the sort of environment in which US dollar bulls retract their horns and the euro starts to gain ground again. The key question is whether the euro’s fundamental appeal stands up to closer scrutiny.
While US growth prospects are expected to suffer next year from global headwinds and the Fed’s tough interest rate tactics, Europe should also feel pain as the risks of downturn and possible recession loom in 2023. According to the Organisation for Economic Cooperation and Development, Germany is expected to succumb to recession next year with gross domestic product forecast to fall by 0.3 per cent in 2023 as economic uncertainties and high inflation drag down growth.
Europe as a whole should be relatively better off, though, with overall euro zone growth expected to be around 0.5 per cent in 2023, matching expected US growth next year. Among the larger European economies, Spain is forecast to grow by about 1.3 per cent in 2023, with 0.6 per cent expected for France and 0.2 per cent for Italy.
Despite the spectre of German recession, the ECB will press ahead with its battle to contain inflation, which has hit Europe particularly hard as global energy prices have surged. With inflation running at 10.4 per cent in Germany, 11.8 per cent in Italy and 14.3 per cent in the Netherlands, there is no way the ECB will give in too soon on its anti-inflation fight.
The ECB has already raised its key interest rates by 75 basis points in September and October and could be on track to converge with US rates by the end of 2023. This should add significant impetus to the euro’s longer-term recovery, with a return to pre-Covid levels between US$1.10 to US$1.25 to the euro on the cards in 2023.
As the tide turns on the US dollar, longer-term currency reserve managers should be looking to reallocate larger shares of their holdings back into euros. According to the International Monetary Fund’s report on the world’s currency composition of foreign exchange reserves, official holdings of euros had fallen below 20 per cent by the second quarter of 2022, compared with around 60 per cent for the US dollar.
As sentiment improves, portfolio reweighting should add more momentum to the euro’s rally. The oversold euro seems set for better times ahead.
David Brown is the chief executive of New View Economics
