The foreign-exchange market is transferring allegiances. The U.S. dollar has gone into reverse, and the euro looks like it could gain further yet.
That wasn't the script that many had for 2017, of course. The dollar was riding high, the euro was beset by populist threats, and parity was on the horizon. Now, the euro, at close to $1.11, is up 5.4% against the dollar this year, versus gains of 4.8% for sterling and 4% for the yen. The euro has climbed markedly out of its post-U.S.-election range in May.
The terms of the exchange-rate equation are shifting on both sides of the Atlantic. Political turbulence emanating from the White House, especially lately, and lackluster economic data have dented the enthusiasm for U.S. assets. In Europe, political risk has receded and growth looks relatively buoyant. From a monetary-policy perspective, the European Central Bank's gradual exit from ultraloose policy is likely to steal the market spotlight from the U.S. Federal Reserve.
That is reflected also in the outperformance of European stocks, a narrowing in the gap between U.S. Treasury and German bund yields, and a slightly steeper yield curve in Germany than in the U.S. That shift should attract cash into Europe, starting to reverse a long period of portfolio outflows that weighed on the euro, with a hint of a turn in balance-of-payments data at the end of 2016, UniCredit strategists note.
True, the ECB is likely to tread carefully. But its bond purchases face important political constraints, and thus have a built-in limit. With deflation risks having faded, the pressure to exit from those purchases, and its negative rate regime, is building. A stronger euro and higher bond yields will be a vote of confidence, as long as they don't shoot abruptly upward. ECB tapering could push the euro up to $1.15, ING thinks.
Europe's politics remain a potential source of trouble. Italy is the obvious candidate for a new bout of worries about the euro's future. But an Italian election may not happen until next year, and the first channel for stress to show up will be in the eurozone government bond market, not in the currency.
For the dollar to regain some allure will probably require big positive shifts in how investors view Mr. Trump's administration and the U.S. economy. In their absence and with the ECB moving center stage, the euro is in the driver's seat.
Write to Richard Barley at firstname.lastname@example.org
(END) Dow Jones Newswires
May 17, 2017 08:05 ET (12:05 GMT)