Is light dawning for the Eurodollar?

Economists have been predicting that President Trump’s new import tariffs could prompt the euro to fall to parity with the US dollar this year. The European Union’s (EUs) recent policy shift in favour of defence spending, however, renewed some belief in their economy and currency. For instance, TD Bank and Goldman Sachs took the potential release of 800 billion euros as a cue to abandon their parity forecast. In their view, the cash injection would buoy up European interest rates and currencies in coming months, so there was a reason to feel less bearish about the EUR/USD pair (which pits the euro against the US dollar) in currency trading. And, indeed, the euro responded bullishly to the EU defense announcements in early March by surging as much as 0.5%, leaving the EUR/USD at the level of 1.0546. After touching a two-year low in early February, the euro had reasserted itself to the tune of 4% within only a month. 

Another important driver of euro strength in recent weeks has been the hope of an imminent peace deal for Ukraine. After Presidents Zelensky and Trump clashed in the Oval Office in late February, instead of signing the mineral deal that could hasten peace negotiations, the euro plunged. 

The end of February also happened to be a bearish time for American currency, which fell on the news of a 0.2% weakening in consumer sentiment in January. As a result, the month of February was the USD’s worst since September 2024, losing 0.8% overall. Markets took the US data so seriously that expectations of a Fed rate cut in June rose to 79.1% despite the fact that those policymakers had indicated they would put off their dovishness for the moment. 

With market participants believing in a better future for Europe’s economy while turning hesitant on US growth, did this spell a bullish path ahead for the euro in its matchup with the dollar?

Shifting to defence

In the words of Rick Meckler of Cherry Lane Investments, “The market likes certainty. It likes a plan”. This is exactly what Ursula von der Leyen, the EU president, gave it at the beginning of March with her new defence strategy. The feeling of confidence was augmented by the decision of Germany’s top four political leaders – Friedrich Merz, Markus Soder, Lars Klingbeil, and Saskia Esken – to establish a fund for infrastructure development worth 500 billion euros over the next ten years. Merz also said he would adjust the constitutional restrictions on fiscal debt to open up capital flows towards defence. These moves seemed to be good news for Europe’s biggest economy in both the short and long terms.

However, the fruits of all these projects will take time to ripen and, in the meantime, “We do… think that things can get worse before getting better”, says BNP Paribas. On Europe’s more imminent horizon is a trade war that looks set to make their economic recovery a lot harder than it was beforehand. Indeed, ING are not fooled by all the talk of European growth, insisting that the key factor guiding the euro will be “the eurozone’s structural unpreparedness to face the consequences of Trump’s tariffs”, which “continues to form the basis of our bearish EUR view” in currency trading. 

Interest rates

As to the market’s concerns about slowing US growth, these convinced some analysts to anticipate more than three Fed rate cuts this year. BNP Paribas say that “We think this is exaggerated and maintain our expectation of maximum two cuts this year”, while expecting the European Central Bank to cut rates twice in 2025, each time by 25 basis points. The interest rate differential would then favour dollar dominance over the euro in currency trading. ING also expect a maximum of two Fed rate cuts this year, and that the Fed won’t be moved to change their minds by the weak consumer data. Thierry Wizman of Macquarie has “a suspicion that this is idiosyncratic on the spending side in January”, so that the data will not prove very significant for policymakers.

Near the end of February 2025, several Fed members including Beth Hammack said they would hesitate to lower interest rates further before seeing concrete data on the economy’s response to last year’s cuts. For Hammack, the risk of reheating inflation is still considerable, “and this will likely mean holding the federal funds rate steady for some time”, she says. This casts a doubt over that 79.1% certainty of a rate cut in June, since – at least much of the time – the Fed do mean what they say.

Wrapping up

If defence spending won’t give the European economy the medium-term boost it needs, then what will? Goldman Sachs see some light at the end of the tunnel because of built-up household savings and a projected rise in real (inflation-adjusted) incomes. Last November, as a result of these factors, Goldman forecasted weak but positive growth for 2025, and only a 30% chance of recession. 

The main worry on those analysts’ minds was the widespread effect of trade uncertainty on Europe’s economy, which they believed would reduce its real GDP by as much as 0.5%, starting in Q1 and peaking in Q3 2025. Plus, there was the ongoing problem of European manufacturers losing business to the Chinese. Energy prices in Europe are well below the highs they saw after the Russian invasion of Ukraine, but, as of mid-February, natural gas prices were still relatively high – holding at $14 per million British thermal units (BTUs), as compared with the price of US natural gas futures at the time, which was only about $4.23 per million BTUs. These structural obstacles may keep Eurozone enthusiasm muted in the months ahead, which would hamper the euro’s potential to gain.