EUR

After narrowly avoiding recession earlier in the year, the euro area economy continues to generate above-target inflation, forcing policymakers to maintain a consistently-hawkish stance. The European Central Bank’s series of interest rate hikes is expected to remain uninterrupted for several months to come, with investors currently pricing in two more moves – one later this month, and another in September. With rate differentials narrowing in its favour and the dollar staging a broad-based retreat, the euro has turned in a respectable performance since bottoming out in late 2022, and gains have accelerated since softer-than-anticipated consumer price numbers drove US yields...

European gas prices remain historically elevated, but have fallen to an 18-month low, and storage levels are tracking well above seasonal averages after a concerted push to lower usage and diversify supply relationships beyond Russia. Although Germany’s decision to phase out nuclear reactors has left the bloc’s largest economy vulnerable to volatility in global fossil fuel prices, new liquified natural gas terminals and storage facilities should limit the likelihood of another energy shock in the winter months. This should reduce pressure on headline inflation, lessen the need for another round of aggressive monetary tightening, and improve underlying consumer confidence levels...

The European Central Bank’s economic projections look increasingly over-optimistic, with a vast array of indicators pointing to a potential double-dip downturn in the common currency area by the end of the year. Support to growth from lower energy prices has faded, housing prices are negative or falling in most core economies, corporate insolvencies are creeping higher as earnings weaken, and S&P’s euro area composite purchasing manager index slipped back into contractionary territory in June. Further weakness beckons: Exports to both of the euro area’s largest markets – China and the United States – are looking vulnerable as the global manufacturing...

We think the euro could continue to appreciate against the dollar into the early autumn on expectations for a divergence in policy between the European Central Bank and its US counterpart, but we hold weaker-than-consensus views on the currency’s longer-term performance. Until economic surprise indices turn in the euro area’s favour and the Federal Reserve ends its tightening cycle in a decisive manner, we suspect the exchange rate will have difficulty sustaining levels above the 1.15 threshold. Economic Surprise Indices