For the last year, the euro has been defying the gravitational laws of global markets.
The single currency has surged against the U.S. dollar, even as German bond yields have collapsed to multidecade lows against their American peers. That's not usually what happens.
The gap between two countries' short-term bond yields is one of the most popular indicators for the exchange rate between their currencies. As yields go up in one region, investors move their money there to capture higher returns, driving up the local currency's value.
But the euro has resisted that relationship. On Tuesday, the gap between U.S. and German two-year yields reached 2.58 percentage points. That spread has only ever been wider in the summer of 1999, and then for only a few days.
Despite this gulf, the euro was one of the world's best-performing currencies last year, rallying 14% against the dollar. It started this year at around $1.20, a three-year high, and speculators are more bullish about the currency than ever before, according to U.S. Commodity Futures Trading Commission data.
Political developments, the eurozone's ongoing bond-buying program and the bloc's unexpected growth spurt have all contributed to the euro's rally. Meanwhile, low German bond yields can probably be blamed on the European Central Bank's continued monetary stimulus coupled with much sought after bunds being a shrinking portion of the pool of eurozone debt.
The current spread between yields would typically point to the euro being closer to $1.01, according to a December analysis by Deutsche Bank.
But most analysts don't believe that this gulf between bond and currency markets heralds future declines in the euro. In December, the average analyst forecast suggested the euro will end the year at $1.19 according to Consensus Economics.
The risk that U.S. growth disappoints and the market downgrades its expectations for Federal Reserve interest rate increases makes some investors think the greenback could fall further against the euro.
"The risk is to the downside--that U.S. growth starts to disappoint," said Didier Saint-Georges, managing director at asset management Carmignac. "The market might well wonder how hawkish the Fed can really be, and that's bearish for the dollar."
Meanwhile, yields on bunds are likely to remain significantly lower than U.S. Treasurys.
The total amount of outstanding German government debt--widely regarded as the eurozone's safest bond market, generating constant demand from investors--is shrinking relative to the rest of the bloc.
Europe's largest economy no longer has a budget deficit, and in the middle of 2017 its debt securities made up just 15.1% of the eurozone's total. That is the lowest since the inception of the single currency in 1999, down from a high of 19.4% at the end of 2007.
German debt available to investors increasingly has shorter maturities. At the end of 2016, the average maturity of German government bonds held by the ECB was 8.14 years. By the end of 2017, it was just 6.56 years, as the Bundesbank increasingly bought shorter-dated debt.
That will keep the pressure on bund yields, even as the ECB continues to wind down its bond-buying program.
But monetary policy and technical factors aren't the only forces at work. The euro is getting a boost from strong economic growth across the eurozone.
Politics is also at play, on both sides of the Atlantic.
"There's been so much politics layered over economics recently," said Jane Foley, senior foreign exchange strategist at Rabobank. "It's a very significant theme in driving portfolio flows now."
Ms. Foley cites political risks surrounding President Donald Trump's administration as a factor likely to keep the dollar down. Mr. Trump has also expressed his own preference for a weaker dollar in the past.
The euro's 2017 rally accelerated after the election of centrist candidate Emmanuel Macron as French President, lifting a cloud over the currency after a period of concern over the potential for populist upsets across Europe.
Still, optimism over the eurozone's economy could fade, while Italy's national election in March could potentially stoke some political concern.
"For years the market was too pessimistic about the prospects for the eurozone, (and) it's possible that we've now gone all the way to the other extreme," said Thanos Vamvakidis, global head of G-10 foreign exchange strategy at Bank of America Merrill Lynch.
"We like the euro in the medium to long term, but in the short term the euro has already overshot both the economic data and the rate differential," he added.
Write to Mike Bird at Mike.Bird@wsj.com
(END) Dow Jones Newswires
January 09, 2018 06:37 ET (11:37 GMT)