Authors: Naomi Rovnick and Dhara Ranasinghe
LONDON (Reuters) – Facing the euro’s worst month since early 2022, analysts are warning the currency’s surge could be another source of global market volatility after swings in the Japanese yen triggered a wave of asset market turmoil in August.
In November, the common European currency weakened against the dollar by just over 3%. It is currently teetering towards the key $1 level under pressure from US President-elect Donald Trump’s proposed trade tariffs, euro zone economic weakness and escalating conflict between Russia and Ukraine, while US growth bets are lifting US stocks and the dollar.
France’s political problems are another potential obstacle, with French consumer confidence at a five-month low and the fate of the fresh government and its budget at risk.
Investors and currency traders are divided on what comes next, however, as the dollar is also vulnerable to inflation tariffs and a rise in public debt, which have shaken confidence in U.S. markets and the economy.
Analysts say this uncertainty could enhance if the euro continues to fall, raising the risk of unexpected currency changes that could upend the highly popular so-called Trump’s trades, which are based on the euro falling as US stocks rise.
“We will have volatility because people will start to think: will we break parity (euro-dollar) or will it come back?” – said Kit Juckes, head of foreign exchange strategy at Societe Generale (OTC).
“At a minimum, what we will see is more debate in both directions about the euro, and I do not trust that these extremely high levels of correlation between assets will continue.”
The August market decline began with yen-dollar swings that surprised hedge funds betting against the Japanese currency and escalated into stock market sell-offs to fund margin calls.
Regulators have warned of market fragility in the face of similar events, with popular market narratives changing rapidly due to high levels of leverage in the system.
“If we cross the (euro-dollar) parity, we will have these kinds of talks again,” Juckes said.
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The Eurodollar is the most actively traded currency pair in the world, and rapid changes in exchange rates can disrupt the profits of multinational companies and the prospects for growth and inflation in countries that import and export goods priced in dollars.
“The euro is the reference point” Barclays (LON:) global head of currency strategy Themos Fiotakis said trade-sensitive countries such as China, South Korea and Switzerland could allow their currencies to weaken against the dollar if the euro falls further, so they can compete with exports from the zone euro.
He added that the British pound, which has fallen just over 2% against the dollar this month to around $1.26, is very sensitive to euro movements.
Market sensitivity to the euro-dollar rate also increased after what currency strategists said was a rush by investors to enter into options contracts that combine bets on the outcomes of Trump’s policies across assets, such as a weaker euro and a rise in the S&P.
“We saw a lot of people trying to invest in (these) contingent outcomes,” Fiotakis said, which could enhance the correlation between currency movements and broader markets.
Investors underestimated the risk, said Alvise Marino, a UBS strategist.
The rate of investor demand for protection against short-term euro-dollar fluctuations stands at around 8%, well below the level of almost 14% when the euro last fell below $1 in October 2022.
“Realized volatility in the currency market is likely to be high, and certainly higher than markets are pricing in,” Marino said.
It recommends clients hedge against currency fluctuations with derivative contracts, which pay off if euro volatility is higher in a year’s time.
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Meanwhile, long-term asset managers are deeply divided on where the euro and dollar will go next, underscoring that this key exchange rate could be bumpy in the coming months.
“We expect the euro to rise to 99 cents by the middle of next year,” said Willem Sels, global investment director at HSBC’s private banking and wealth unit.
But Vincent Mortier, chief investment officer at Amundi, Europe’s largest asset manager, said euro zone interest rate cuts could boost business and consumer spending in the euro zone and lift the euro to $1.16 by the end of 2025.
Traders in the fast-moving currency options market behind schedule on Tuesday priced in a 56% probability that the euro will be higher than its current year-end level of around $1.047, despite substantial banks like J.P. Morgan and Deutsche Bank (ETR:) says a transition to $1 could happen, depending on tariffs.
Growing hopes that the European Central Bank will cut interest rates by half a percentage point to 2.75% next month weakened the euro.
However, the popular market narrative is that Trump’s aggressive growth policies and import taxes will enhance U.S. inflation and keep interest rates high, and the power of the dollar is also starting to wane.
Eurizon SJL Capital CEO Stephen Jen said the United States risks the so-called bond guard moment if White House lenders in the $27 trillion Treasury market raise borrowing costs in an attempt to limit tax cuts financed by excessive borrowing.
Consistent tightening in financial conditions “should allow for a soft landing in the U.S. economy and lower long-term interest rates,” he said, causing a revaluation of the dollar.
