Authors: Sruthi Shankar and Alun John

(Reuters) – The euro hit its strongest level against the dollar this year, emerging as the clear winner from recent turmoil in global currency markets that has shaken the robust dollar and halted the Japanese yen’s inexorable decline.

After decisively breaking through the symbolic level of $1.10, the euro gained over 2.5% in August and recorded its best month since November.

Traders, so far distracted by the yen’s sudden rally following the Bank of Japan’s surprise interest rate hike on July 31 and the dollar’s acute strengthening on rising expectations of U.S. rate cuts, are now paying attention.

After all, history shows that $1.10 is not an simple level to break, and as recently as April, some analysts speculated that the euro could weaken towards parity.

It is now the second-best performing currency against the dollar this year, after sterling, and its highest on a trade-weighted basis on record, although that is also due to weakness in emerging market currencies.

Still, the dollar’s gains, which are expected to moderate from now on, are noteworthy as talk of a rate cut by the US Federal Reserve comes amid speculation that further monetary easing by the European Central Bank may be circumscribed by high services-sector inflation.

“It’s a question of the interest rate differential,” said Volkmar Baur, a currency analyst at Commerzbank (ETR).

“Inflation is falling on both sides (of the Atlantic), but the Fed is expected to move a bit more aggressively downward, which would close interest rate spreads a bit and pave the way for a stronger euro.”

The ECB, which cut interest rates in June, could make at least two more cuts of 25 basis points, market valuations suggest.

Traders, by contrast, see 94 basis points of Fed rate cuts at the three remaining meetings this year — that’s three 25-basis point moves, with a good chance of one larger. That’s about a 30-basis point change since early August; the ECB’s prices have changed much less.

The change comes after delicate U.S. jobs data raised recession fears and rattled stocks and bonds. Markets have since calmed, but expectations of policy easing remain.

Of course, not only did the euro strengthen against the dollar in August, but the common currency poses the fewest complications for investors seeking relatively protected investments in the currency market.

The yen is volatile after a huge carry trade ended. Sterling gained less in August after a UK rate cut and French political risks that hurt the euro in June receded.

“We saw the euro contain some risks, like the French election,” said Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International.

“This is now becoming a cleaner central bank story.”

WHAT’S MORE DIFFICULT

However, from this point on, the euro may find it tough to strengthen further.

Analysts say the rate is at the top of recent trading ranges and there is less likelihood of interest rate differentials shifting in its favor.

Commerzbank forecasts the euro will be $1.11 by year-end, unchanged from current levels. ING predicts the euro will be $1.12 in a month, then fall to $1.10, and BofA expects $1.12 by year-end.

“My view since Q2 2023 has been to play in a trading range. You buy the euro at $1.05 and sell once it goes above $1.10,” said Mathieu Savary, chief European investment strategist at BCA Research.

For some, this may even be the end of profits.

“These are the highest levels you can expect for the euro between now and the end of the year,” said Guy Stear, head of developed markets strategy at Amundi Investment Institute, who believes the case for further ECB rate cuts is more compelling than that for the Federal Reserve.

The recent economic recovery in the eurozone is showing signs of slowing, with German investor sentiment recording its sharpest decline in two years in August.

Meanwhile, the next round of U.S. employment data could show that July’s delicate report was just a fleeting setback caused by Hurricane Beryl.

Another factor complicating the situation is the US presidential election, which will take place on November 5.

While there are many variables at play, analysts say Republican candidate Donald Trump’s policies of higher tariffs and lower taxes will likely lead to higher inflation, which means tighter Federal Reserve policy and a stronger dollar.

Rabobank’s head of currency strategy Jane Foley noted that the euro’s recent rise came on the back of a rise in support for his Democratic rival, US Vice President Kamala Harris, in opinion polls.

“The factor that could actually push the euro/dollar rate above $1.10 and keep it at that level is a Harris victory and an economic slowdown in the US,” she said.