As euro breaks above $1.08, is dollar parity out of the picture?

23 March, 2017

The euro has appreciated by about 4% from its January lows when it touched a 14-year trough of 1.0340 against the US dollar at the height of the dollar rally. The receding threat of a major advance by populist parties across Europe’s political landscape has propped up the single currency in recent weeks, confounding some predictions made late last year that the euro would hit parity with the dollar as early as in the first quarter of 2017.

While uncertainty about the timing and size of President Trump’s tax cuts in the United States has been a setback for dollar bulls, positive developments in European elections as well as increasing signs that the European Central Bank’s next move will be to tighten policy have provided an additional boost to the euro, lifting it back towards the key $1.08 level this week.

The Dutch election outcome on March 15 when Geert Wilder’s far-right party lost out to the incumbent prime minister, Mark Rutte’s centre-right party, was a big relief for the markets as well as for Europe’s political leaders. Last year’s surprise results of the UK’s EU referendum and the presidential election in the US had raised concerns that more shocks could be on the way by voters amid rising populism in many Western nations. Monday’s presidential TV debate in France was the latest trigger to spur a fresh upwards drive for Europe’s struggling currency after the centrist candidate, Emmanuel Macron, came out the strongest in the debate, pushing himself ahead of his main rival, Marine Le Pen – leader of the far-right National Front party – in the latest French polls.

The euro hit a 7-week high of 1.0824 dollars today, making it its third attempt since the US election to break above the 1.08 level. However, it’s too early to say if the latest upswing will prove third-time lucky given that the previous attempts in December and February failed. Without a sustained rally that would take the pair above December’s peak of 1.0874, it would be difficult to say that the euro has reached a turning point and that dollar parity is no longer within sight.

With several key risk events still ahead, the euro looks set for a bumpy ride in whichever direction it travels. First up, the French elections on April 23 and May 7 are far from certain to deliver a win for a centrist candidate. The German elections in September may seem the least risky as the mainstream parties are well ahead in the polls, but a strong showing for far right and left parties could produce a shift in policy towards the European Union by all the major parties. Italy is not out of the woods either as an early election in 2017 is still possible, plus, with more state bailouts for troubled banks on the way, the country’s government could run into trouble with the EU, which toughened the rules on tax-payer funded aid after the Eurozone debt crisis.

Also casting a shadow over the Eurozone is the upcoming negotiations with Britain following its decision to leave the EU. A prolonged period of painful and acrimonious negotiations could weigh on the euro, as, apart from the uncertainty it would create until an eventual deal is reached, it could open up divisions among EU members.

The possibility of a trade spat with the US is another risk hanging over the single currency as the Trump administration sees Germany as a currency manipulator due to its large trade surplus. However, this is more likely to be negative for the dollar based on investors’ reaction to Trump’s protectionist stance so far. Most importantly though, the dollar’s strength will very much depend on whether the Federal Reserve sticks to its three rate-hike path or raise rates more aggressively, which in turn depends on the Trump administration being able to pass through its fiscal stimulus plans this year.

A resumption of the dollar rally could be the catalyst needed to drive the euro towards parity. However, with improving economic fundamentals for the Eurozone, monetary policy between the US and the euro area is not as divergent as it was in 2016 when the Fed was tightening and the ECB was easing. The ECB will likely start to scale back its asset purchase program at the start of 2018 as inflation recovers and growth gathers momentum. An increase in the central bank’s deposit rate from the current record low level of -0.40% may even come before then, limiting the downside bias on the euro.

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