Euro is reluctant wearer of King Dollar’s crown

EUphoria. It is a victory Pyrrhus would have been proud of. The euro is soaring against the dollar even though traders expect the bloc’s interest rates to fall more than U.S. ones, which should in theory lead to a stronger greenback. There are good reasons for the moves, but a strong currency will further strain the euro zone economy.

The euro has risen nearly 3% against the dollar this month and on Wednesday hit $1.117, the highest level in more than a year. The move runs counter to the idea that interest-rate differentials drive currencies. Traders are betting that euro zone rates will hit 2.3% in July 2025 from 3.75% now, while U.S. rates are only expected to fall to 3.4% from around 5.4% now, according to derivatives prices collected by LSEG. In theory, that gap should drive demand for U.S. assets and strengthen its currency.

In practice, several factors are pushing it down. The first is the market’s fear that the U.S. Federal Reserve will sanction bigger and faster rate cuts if the domestic economy and labour market take a turn for the worse. The second is political uncertainty. Republican presidential candidate Donald Trump has said he wants a weaker dollar if he wins the November election.

The third concern is Washington’s debt burden. The Congressional Budget Office forecasts that federal borrowing will exceed 122% of GDP by 2034, from less than 100% now. And, finally, the dollar may still be suffering the aftershocks of this month’s unwinding of the “carry trade”. That strategy increased demand for the greenback because investors borrowed Japanese yen to buy dollar-denominated assets.

Still, the euro’s rise is a headache for European Central Bank President Christine Lagarde. A strong currency increases the prices of exports, making them less competitive. That’s a problem because selling goods and services abroad accounts for nearly a third of the euro zone’s GDP. In the first quarter of 2024, exports increased by 1.3% over the previous three months, offsetting sluggish growth elsewhere.

Lagarde could cut rates even faster to counteract the effect, but that would be risky while inflation remains above the ECB’s 2% target. Or she could hope the dollar regains its strength – for example if a global shock sparks a flight to the safe haven of Treasuries, or if the gravity of interest-rate differentials eventually takes hold.

Until then, the euro zone economy will have to hope the ECB can snatch a currency defeat from the jaws of a Pyrrhic victory.

Context News

The euro hit the highest level against the U.S. dollar in more than a year on Aug. 21. The European single currency hit $1.1173, the highest level since July 2023, as traders focused on the potential for interest rate cuts in the United States. The euro is now the second-best performing currency against the dollar this year, after the pound.