Euro: Gains hinge on domestic demand – BNY

BNY’s Geoff Yu notes that recent EUR/USD support has come mainly from cross-border investors reducing hedges after the European Central Bank's (ECB) hawkish shift, bringing aggregate Euro holdings back to flat. However, he argues that further Euro (EUR) gains will increasingly depend on domestic and EUR-based investors, as current fundamentals make a sharp move in rate differentials or extreme Dollar weakness unlikely in the near term.

Cross-border flows face limits

"Last week we highlighted how the ECB decision is finally generating positive rate-differential flows on EUR crosses. Even EURUSD is finding its footing ahead of the decision, and this has helped the currency recover its holdings to flat for the first time in over two months."

"Even with a hawkish ECB relative to peers, we believe it’ll be difficult for cross-border investors to reduce hedges further due to nominal differentials, unless there is surge in flows into underlying assets without a commensurate gain in hedging (forward EUR sales). This means that the marginal demand in EUR holdings will have to come from onshore investors or EUR-denominated accounts."

"This will only happen if USD strength hits extremes and/or rate differentials move sharply in favor of the EUR. We find both hard to achieve in the near future based on current fundamentals."

"For the eurozone economy, we still believe the best approach is for the ECB to signal that aggressive tightening is not the base case, allowing some easing in financial conditions through rates and even the currency."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor.)