Euro-Dollar Hits One-month Best in Tariff Breathing Space

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The Euro is rising against the Dollar as President Donald Trump indicates there is room to negotiate on tariffs, lowering the odds of a fall to parity in value.

The Euro to Dollar (EURUSD) exchange rate reached its highest level since December in midweek trade as traders expressed relief that worst-case tariff scenarios look increasingly unlikely.

To be sure, the European Union will pay higher tariffs under Trump, but the expectation is that there is ample wriggle room for EU leaders to lessen the blow.

"We have a $350 billion deficit with the European Union. They treat us very very badly, so they’re going to be in for tariffs," said Trump on Tuesday.

However, he indicated a day earlier that a potential route forward would involve the EU buying more U.S. oil and gas, which would lower the trade deficit.

In short, negotiations lie ahead and Trump is using maximalist tariff threats as a bargaining chip.

"Europe was also threatened with tariffs if it did not purchase more natural gas from the U.S. All told, the actions taken are certainly considerably less than what could have happened and indeed what many market participants were expecting," says Derek Halpenny, Head of Research for Global Markets EMEA at MUFG Bank Ltd.

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For its part, the EU is ready to negotiate. "The priority is to have a conversation, to engage early, discuss common interests and then be ready to negotiate," said Anna-Kaisa Itkonen, the European Commission’s spokesperson for energy.

This immediately lowers the trade risk premium in the Euro-Dollar, allowing it to lift to 1.0433, where we now find it.

"EUR/USD remains cheap and oversold... We estimate that the pair is still trading around 1.5% below its short-term fair value, signalling some tariff-related risk remains in the price," says Francesco Pesole, FX Strategist at ING Bank.

Above: EURUSD is back at levels seen in December.

Trump could raise tariffs on Mexico and Canada as soon as February 01, but it looks as though these tariffs must be considered in the context of domestic issues and not purely trade dynamics.

This as the new president is using the threat of tariffs to pressure his two neighbours into helping him stop the flow of illegal migrants and drugs into the U.S.

MUFG's analysts warn that it is still highly likely that considerable tariff actions are coming, but in what way
and exactly when remains unclear.

Trump has tasked federal agencies to investigate current trade dynamics and potential remedies, asking them to report back by April 01. By this time, Jamieson Greer will be installed as U.S. trade representative, allowing him to spearhead Trump's trade agenda.

EURUSD Parity Odds Lessen

It is almost certain Trump will continue to talk about trade and tariffs ahead of this date, meaning foreign exchange markets will see bouts of headline-driven volatility.

Uncertainty is a natural ally of the U.S. Dollar, suggesting Euro-Dollar recovery potential will have clear limits.

Nevertheless, "at this juncture, the risks of EUR/USD dropping below the parity level this quarter has come down somewhat," says MUFG's Halpenny.

Above: Fundamental growth dynamics advocate for ongoing EURUSD weakness. Image: UBS.

Parity Merely Delayed

However, Jane Foley, Senior FX Strategist at Rabobank, thinks the journey to parity is merely delayed, not cancelled.

"While over-extended long USD positions suggest that there is scope for pullbacks near-term, we maintain the view that EUR/USD could hit parity in Q2," she explains.

Rabobank thinks inflationary pressures are still a risk from Trump's domestic and foreign policies, allowing the Federal Reserve to cut rates just once more this year, in March.

"There is risk that this window could close if inflation risks increase rapidly. In contrast, the ECB is likely to continue cutting rates into the spring, with the next move likely next week. This should cap momentum in any further pullbacks near-term in EUR/USD and allow for further downside potential in the coming months," says Foley.

Dominic Schnider, Strategist at UBS, says EURUSD is likely to slip to parity before a broader reversal takes place.

"In our base case, dips below parity should still be short-lived and can be used to reduce excessive USD long exposure. Boundaries: We look for technical support at around 1.00 and then 0.985 to the downside. To the upside, we see resistance around 1.05," he says.