A combination of economic recovery in the Eurozone and external factors are expected to propel the EUR/USD exchange rate even higher still over the coming quarters.

The common currency has risen by nearly 4% against the US Dollar during the last month, to trade above 1.2500 twice in the last week, which takes its 12 month gain to around 16%. The trade weighted Euro is up by nearly 10% on a one year horizon.

Broadly speaking, a combination of economic recovery in the Eurozone and external factors are expected to propel the exchange rate higher still over the coming quarters.

“In our 2018 Outlook, published in early November, we extended our long-held view that the EUR was cheap, the USD expensive, and that convergence in economic cycles was likely to catalyze EUR/$ appreciation towards 1.25 this year,” says Yianos Kontopoulos, a strategist at UBS, in a recent note.

The strength of the Euro-to-Dollar exchange rate has left many a commentator scratching their heads in recent weeks, particularly as the Federal Reserve remains firmly committed to raising US interest rates three or more times in 2018 and Eurozone rates are going nowhere anytime soon.

Now, with President Donald Trump’s tax reforms going into effect, US growth, inflation and interest rates could rise further still in 2018. But yet, the Euro-to-Dollar exchange rate has continued to score fresh multi-year highs right through January.

“The Federal Reserve is the central bank that is the furthest in the normalisation process, it makes sense to judge that most other central banks have a larger scope for catching up,” proffers Martin Enlund, an analyst at Nordea Markets.

“This notion could be what the FX markets reflect via a weaker USD against all major currencies, including the EUR.”

Above: EUR/USD shown at four hour intervals. Captures January 2018 price action.

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Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here.Nordea's Enlund argues that it makes sense for markets to reallocate away from the US Dollar as it because the world economy has now fully recovered from the effects of the financial crisis and is entering a period of synchronised global growth.

Faster global growth means global inflation and interest rates could soon be rising in tow and, given that the Federal Reserve is already two years into a hiking cycle, there is now less upside to be had from betting on the US Dollar.

Relatively speaking, returns for traders and investors will be better if they stack their chips behind other currencies - which is what they have been doing.

“That said, the speed at which these market shifts have occurred has been even faster than we expected, as the breadth, depth and persistence of the global growth acceleration has weighed on the dollar and lifted yields,” says UBS’ Kontopoulos.

The theory on global growth and relative attractiveness would explain the widening gap between yields on two year US government bonds and two year German government bonds.

The so called “two year rates spread” is now in excess of 2.6%, meaning investors get around 2.6% more yield for holding short term US government debt than they do from holding German debt.

This its highest level since before the financial crisis, and recent history would dictate that it command a higher Dollar, but the greenback is still falling against the Euro and other currencies.

“The current market environment is starting to look reminiscent of the period between 2004 and 2007. Back then, the USD weakened when risk appetite was solid and was bought when risk appetite deteriorated; this is now widely back in the markets,” Nordea’s Enlund says.

Above: EUR/USD shown at weekly intervals. Captures pre-quantitative easing peak and QE trough.

Incidentally, economists at UBS have just revised their forecast for global economic growth in 2018 up by 20 basis points, to 4.1%, to reflect a surprisingly strong finish to 2017 and a good start to 2018. Strategists at the bank also forecast a continuation of recent trends in currency markets.

“There is more to go... The dollar is still expensive. Easy financial conditions, a weak dollar and higher oil prices are, for the first time in a while, creating conditions for a benign normalization to inflation, from a low starting point,” Kontopoulos writes.

However, the UBS strategy team also note that the recent pace of gains for the Euro, and weakness for the Dollar, will be difficult to replicate again, in part due to the sheer divergence between monetary policies in the US and elsewhere.

This chimes with upgraded views from Nordea’s Enlund, who forecasts a slower pace of gains for the Euro during the next three to six months, based on the expectation that the European Central Bank will soon start to push back against the Euro’s strength.

So far, the ECB has done little to curb the currency’s appreciation, instead attributing it largely to external factors.

“We see EUR/USD around 1.21-1.22 in three to six months’ time followed by a continued path towards 1.33 towards the end of 2019,” Enlund wrote in a note Thursday.

For the end of 2018, Nordea Markets strategists now forecast the EUR/USD exchange rate will rise to 1.2700 by year end, which is an upward revision from their forecast of 1.20 just a few weeks ago. The team at UBS are even more bullish.

“All told, our previous forecast targets require an update to the developments in UBS economic views and to the prevailing market levels. We are raising our EUR/$ forecast to 1.30 for end-2018 and 1.35 for end-2019 (from 1.25 and 1.30),” Kontopoulos says.

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Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here.