(Bloomberg) -- Traders are ramping up bets for a deeper divergence between European and US interest rates, setting the euro on a clear path for further weakness.
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Soft inflation readings from Germany and France on Friday strengthened the argument that the European Central Bank will continue monetary easing this year following a rate cut on Thursday. Meanwhile, the Federal Reserve kept rates on hold on Wednesday and hinted at a pause, ensuring the dollar remains a much more attractive currency.
The big question now is how deep the euro’s decline will turn out to be, with many forecasters betting that parity with the dollar is possible in the coming months. Traders are now fully pricing in three more cuts by the ECB before the end of the year and predict there’s an almost 30% chance of a fourth reduction. The central bank may have to go deeper if US President Donald Trump acts on a pledge to impose punitive trade tariffs.
“This week’s central bank meetings confirm the divergence in policy,” said Matthew Landon, a global market strategist at J.P. Morgan Private Bank. Tariffs could further widen that gap, “bringing the possibility of euro-dollar parity back into contention,” he added.
Data published Friday show a fall in regional German inflation and an unexpectedly steady reading of French prices. That follows a Thursday release showing that euro zone growth stagnated in the fourth quarter. At the same time, solid US growth adds to the argument that the Fed will hold off easing.
After slumping to a two-year low of $1.0178 earlier this month, the euro has recovered on relief that Trump didn’t impose tariffs on Europe in his first few days in office. The currency fell to $1.0365 on Friday, while bunds extended their rally after Thursday’s rate decision. The two-year yield fell 8 basis points to 2.13%, its lowest level in four weeks.
Options traders are bearish on the euro across tenors, while the premium to hedge against short-term weakness has doubled since Wednesday. Meanwhile, the total notional of trades targeting a euro drop to parity with the dollar doubled in January from the previous month, according to DTCC.
“Parity is still possible if the strong run of US data continues, or Trump comes out with tariffs,” said Van Luu, global head of currencies at Russell Investments.