Euro Optimism Gets a Reality Check, as Investors Reevaluate Rate Prospects

Euro bulls may have to temper their exuberance after the rush to invest in the single currency, which may have left it vulnerable in the short term, especially given the uncertainties surrounding the interest rate plans of several major central banks.

The euro reached its highest level in ten months versus the dollar earlier this month, having risen 13% from a 20-year bottom of $0.9528 in late September.

The likelihood of a softer recession as a result of lowering energy prices and sufficient natural gas supplies, combined with China finally emerging from three years of tough COVID restrictions, has piqued investor interest in European assets in general.

Euro Vulnerable

However, the euro appears vulnerable, at least in the medium term, as a result of this enthusiasm.

The euro is projected to fall for the second week in a row and is now trading at $1.075.

I’m still bullish on the euro, but our positioning data reveals that current longs in euro, or what we call ‘current over-held positions,’ have reached a record high,” said BNY Mellon EMEA analyst Geoffrey Yu.

At current levels, the bar for additional longs or adding new euro exposure is exceedingly high.

The custodial bank’s proprietary iFlow positioning data revealed that its clients’ long euro holdings against all other currencies (bets on the euro rising) are over four times bigger than the average position over the last 20 years, a series high.

Yu said some rebound was needed from September when “everyone was fairly gloomy on the eurozone economy“, but “this is overpricing things“.

According to the statistics, underweight positions in euro were over three and a half times their usual size in September.

Rate Differences

The Commitment of Traders report from the Commodity Futures Trading Commission paints a similar picture.

According to the most recent data, net long euro positions increased to $18.3 billion in the week ending January 24.

The euro’s rise has not only come at the expense of the dollar. It reached a five-month high versus the pound last week and a near 14-year high against the Swedish crown this week.

Rates Starting to Move

The European currency gained ground against the dollar as investors braced for the potential that the Federal Reserve of the United States may stop rising interest rates before the European Central Bank.

The Fed is also likely to lower interest rates
faster than the ECB.

Higher or lower interest rates didn’t matter as long as petrol prices were such a big driver for the euro. Lower gas costs are now allowing markets to consider interest rate differentials between Europe and the United States” ING currency strategist Francesco Pesole said.

In theory, a currency with higher interest rates attracts more investment than one with lower interest rates.

When the euro hit a 10-month high versus the dollar in early February, futures markets revealed the smallest premium in dollar loan rates over euro rates since late 2021.

This premium extended last week, however, as very solid US employment statistics fueled views that the Fed has room to raise interest rates further, forcing the euro to fall.

However, ING believes that the Fed will cut rates significantly in the second half of this year, and that interest rate differentials would once again push the euro/dollar pair.

They predict that the euro will be worth roughly $1.15 by the end of the second quarter of 2023.

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