The dollar has climbed to an 18-month high, and strategists say fiscal stress in France and Italy is now reinforcing the US currency's advantage. The euro slipped against the dollar as bond-market tension between the two European countries widened sharply, and analysts expect further euro weakness in the near term.
Europe's bond stress feeds the dollar trade
The US dollar has surged to an 18-month high this fall, with uncertainty across the Atlantic emboldening investors to bet on further dollar appreciation. Analysts say the currency keeps drawing support from high and likely rising US interest rates, resilient economic growth and persistent inflation risks.
But Europe's troubles are becoming just as important to the trade. Large deficits in France and the prospect of stress spreading to Italy and the rest of the bloc are emerging as a likely driver of dollar performance in the coming months.
The spread between French and German 10-year bond yields posted its biggest weekly jump in decades last week, while the Italian-German yield gap saw its steepest weekly increase since the COVID-19 pandemic. The euro was last down 0.67% against the dollar at 1.1183.
Uto Shinohara, senior investment strategist at Mesirow Currency Management, said the euro remains under pressure, limiting one of the dollar's main alternatives. Karl Schamotta, chief market strategist at Corpay in Toronto, said there's a lot of focus on countries where political dysfunction is preventing a return to sustainable fiscal trajectories.
ECB hikes fail to lift the euro
The greenback has appreciated about 5% against the euro this year, helping lift the dollar index, which measures its strength against six major currencies including the euro, its largest component. One concern is that the euro is no longer drawing much support from hawkish signals out of the European Central Bank.
The ECB raised interest rates by 25 basis points in September, the second hike this year aimed at quelling an energy-driven rise in inflation. Yet the euro fell after the decision as markets worried about the economic impact of future hikes. Higher European yields have typically supported the euro, but its muted response suggests investors are increasingly focused on growth and fiscal risks, and rising energy prices could add further pressure.
Benjamin Ford, a researcher at macro research and strategy firm Macro Hive, said Europe is a major energy importer and more reliant on manufacturing than the US, so high energy prices will hold the region back. Ford expects the euro to fall to $1.10 within the next month, nearly 2% below its current level.
Investors brace for a policy error
Investors are also weighing whether the ECB can keep fighting inflation without inflicting greater damage on an economy already showing signs of strain. Euro zone inflation surged more than expected in September and is likely to rise further in the coming months on soaring energy costs, keeping pressure on the ECB to raise rates.
Dan Tobon, head of G10 FX strategy at Citi in New York, said the asymmetry around where the euro can go is skewed to the downside, and one place that could come from most easily is a policy error by the ECB over-tightening into a market that can't withstand it anymore. According to Reuters, Citi's Tobon said: "As of right now, this skew is very much looking ugly for Europe."
One-month euro risk reversals, which measure whether options traders are paying more to hedge against euro losses than gains, were at their most bearish since March on Friday, while the three-month measure hit its most negative level since June 2024.
Fed policymakers have signaled that inflation risks remain elevated, keeping Treasury yields at multiyear highs. Fed funds futures are showing about an 84% chance for at least one more rate hike of 25 basis points by December. Few strategists are forecasting a dramatic surge in the dollar from current levels, but they say resilient US growth, elevated yields and Europe-specific risks continue to tilt the balance in the dollar's favor.
Source: Investing.com (Reuters)
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