As the new year unfolds, the global financial landscape has painted a promising picture for non-U.Scurrencies like the euro, which has surged against the dollar, marking a notable upward trajectoryThe exchange rate of the euro to the dollar recently peaked at its highest level in nine months, dramatically reversing the trends observed last year.

The question on the minds of investors is clear: Why are they optimistic about the euro? What strategic decisions can we expect from the European Central Bank (ECB) this year? And what economic hurdles still linger within Europe’s financial landscape?

The Worst May Be Over

In the preceding year, the U.S

Advertisements

dollar enjoyed a robust ascent, largely fueled by the Federal Reserve's series of aggressive interest rate hikesIn stark contrast, non-U.Scurrencies suffered significant setbacks, with July 2022 marking a critical point when the euro fell below the parity line against the dollar for the first time in two decadesBy the end of September, it touched a new year low of 0.95 against the dollar.

However, as we entered this year, the tide began to turn favorably for the euroIn mid-January, it surged to reach nine-month highs against the dollar, and it has shown resilience in maintaining this rate.

Analysts from Deutsche Bank and Morgan Stanley anticipate that the euro could climb further, estimating a potential rise to 1.15 USD

Advertisements

Meanwhile, Gareth Gettinby, a fund manager from Aegon Asset Management, outlined plans to increase their euro positions, indicating a shift in sentiment among investors.

Will Rhind, CEO of GraniteShares, remarked that despite persistent concerns, Europe appears to be on a path to recovery, suggesting the worst of the energy crisis may have passedInterestingly, Europe's market performance outstripped that of the U.Sin the same year.

As 2023 prompts further declines in the dollar, it has buoyed optimism for the euro’s prospectsThe onset of the new year saw hedge funds ramping up short positions on the dollar, leading to a notable fall in the dollar index to near an eight-month low.

Zhang Jingjing, chief macro analyst at China Merchants Securities, emphasizes that with the U.S

Advertisements

manufacturing and non-manufacturing PMI indices trending downward and indicators of softened wage growth, the market expects reduced inflationary pressures, enticing further declines in the dollar index.

Economists at Wells Fargo note that since the Federal Reserve is no longer the primary driver of interest rate hikes, and amid the anticipated downturn in the U.Seconomic landscape, the dollar is entering a downward cycle against most foreign currencies.

Recent statements from Federal Reserve officials have indicated that the era of large-scale rate hikes is behind usRecent U.Sinflation data provides further insight, revealing the Consumer Price Index (CPI) rose by 6.5% year-on-year this past December, aligning with market expectations and showcasing a significant decline from prior values; core CPI also marked a year-on-year increase of 5.7%, a reduction from previous values and the lowest level since December 2021.

Thus, there is consensus among market analysts that the Federal Reserve may only opt for a modest 25 basis point rate hike in their upcoming February meeting.

In summary, the substantial rally of the dollar last year can be attributed to various factors, which are not expected to continue into this year

Although the dollar remains strong, comparative growth prospects indicate a depreciation aheadFurthermore, Europe’s fiscal policies are seen as more conducive to economic growth compared to the U.S., yielding a favorable environment for the euro as monetary policies evolve.

Resilience Beyond Expectations

Surprisingly, Europe’s economic resilience exceeded market expectations last yearJanuary marked a turning point for the eurozone, with commercial activities registering their first expansion in six monthsThe preliminary data from the eurozone Purchasing Managers’ Index (PMI) rose from 49.3 in December to 50.2 in January, indicating growth has returned with a reading above 50.

In an interview, Chen Dong, the head of macroeconomic research at Pictet Wealth Management Asia, emphasized that expectations of a widespread energy crisis in Europe following the onset of conflict have not materialized as anticipated

alefox

There has been an ample supply of natural gas reserves without any significant shortages, coupled with fiscal policies across European countries that cushion household and business sectors against the shock of energy prices, particularly in Germany where fiscal subsidies related to energy represent 7%-8% of GDPOverall, Europe’s economic performance in 2022 exceeded predictions.

The warm winter experienced in Europe has further alleviated heating demand, which has been a boon for natural gas inventoriesAccording to data from the Gas Infrastructure Europe (GIE), as of January 17, 2023, the storage level across the EU reached a record high of 81.07%, a remarkable achievement compared to the ten-year average level by 40%. Enhanced inventory levels have driven down natural gas prices and eased the energy crisis gripping Europe.

Gradual Rate Increases

Despite the evident easing of the energy crisis, the fundamental issues surrounding Europe’s energy supply remain unresolved

Additionally, inflationary pressures continue to loom over the eurozone and are not expected to dissipate anytime soon.

Recent figures for the eurozone's CPI indicated a year-on-year growth rate of 9.2% for December, a decline from the previous month’s 10.1% and marking a four-month lowNevertheless, the core inflation, excluding volatile categories such as energy, food, and tobacco, reached a historical high of 5.2%.

ECB President Christine Lagarde cautioned that the market should not assume a peak in eurozone inflation or an imminent halt to interest rate hikesKey inflation metrics, including overall and core inflation, remain pressing issues and are still deemed excessively high from various perspectives.

The ECB's first rate-setting policy meeting for 2023 is set for February 2. Current market speculation suggests the ECB will proceed with its December commitment to a 50 basis point hike.

Surveys conducted among economists indicate reluctance among officials to ease monetary policy post-February, even amidst unfavorable inflation rates coupled with declining energy prices

The ECB is likely to maintain a 50 basis point rate hikeHowever, some members of the board have expressed favor for a more incremental approach.

Steve Englander, head of G10 global foreign exchange research at Standard Chartered, noted that the strengthening core inflation and economic surprises in the eurozone potentially posit a hawkish stance from the ECB, which could last longer than the path taken by the Fed.

Analyzing the current trends, Chen Dong predicts that the ECB may continue its rate hikes longer than the Fed, possibly extending until May this year.

Furthermore, JPMorgan strategists have also cited that a more hawkish ECB compared to the Fed will serve to bolster the euro in the coming months.