According to BNY’s Geoff Yu, recent support for the EUR/USD currency pair has primarily resulted from cross-border investors reducing their hedges following the European Central Bank's (ECB) hawkish policy shift, which has brought aggregate Euro holdings back to flat for the first time in over two months [1]. Yu notes that the ECB's decision has generated positive rate-differential flows on Euro crosses, contributing to the Euro's stabilization ahead of the central bank's announcement [1].
However, Yu cautions that further gains for the Euro will increasingly rely on domestic and EUR-based investors, as the current market fundamentals do not support a sharp move in rate differentials or a significant weakening of the US Dollar in the near term [1]. He explains that cross-border flows are facing limits, and unless there is a surge in flows into underlying assets without a corresponding increase in hedging, the marginal demand for Euro holdings will need to come from onshore investors or EUR-denominated accounts [1].
Yu further argues that such a shift in demand is unlikely unless USD strength reaches extreme levels or rate differentials move sharply in favor of the Euro, both of which he finds hard to achieve based on current fundamentals [1]. For the eurozone economy, Yu suggests that the best approach for the ECB is to signal that aggressive tightening is not the base case, which would allow some easing in financial conditions through both rates and the currency [1].
CONCLUSION
BNY’s analysis indicates that the Euro's recent stabilization is largely due to cross-border flows, but further appreciation will require increased domestic demand, which appears unlikely given current fundamentals. The ECB is advised to avoid signaling aggressive tightening to support more accommodative financial conditions. Overall, the outlook for significant Euro gains remains limited in the near term.