Above: Terminal, Shanghai, China. Image © Adobe Stock

Can the euro continue to rise in value or is this a mere relief rally within the confines of the long running decline against the Dollar?

According to analysts at Barclays the answer to the question of where the Euro heads next could actually be found in China.

"The China impulse is far more important than the European and the US impulse combined. Overall, unless China eases policies a lot more and/or until mobility restrictions start to ease, China growth risks will likely present an ongoing drag for the EUR in the near term," says Themistoklis Fiotakis, an analyst at Barclays.

Above: "China reopening and a reduction in risk premium drove the majority of the eur/$ rebound" - Barclays. Image and data source: Bloomberg, Barclays Research.

Chinese growth has fallen sharply over recent months as authorities there cling on to their zero-Covid approach to the coronavirus.

The shutdown has seen vast cities and regions closed - most notably Shanghai - which has seriously dented global economic growth and supply chains.

This has in turn impacted directly on the Eurozone's economic performance as well as broader risk sentiment which has deteriorated and sparked demand for the dollar.

But there are signs of hope with authorities in China starting to allow Shanghai to reopen and data suggests the overall spread of coronavirus might have peaked.

"China vs US growth data will drive the EUR/$, with the former being more significant," says Fiotakis.

The call comes days after the Euro to Dollar exchange rate slumped to a new multi-year low at 1.0348 before turning higher to quote at 1.0676 at the present time.

Against Sterling the Euro has been even more bullish with the Euro-Pound exchange rate trending higher from a low of 0.8203 in March to 0.8498 today.

Analysts have largely attributed the Euro's recovery to the about-turn in the European Central Bank's (ECB) stance towards monetary policy that means an interest rate rise in July is likely.

In fact ECB President Christine Lagarde suggested earlier this week the Deposit Rate could be out of negative territory by September, suggestive of two incoming 25 basis point hikes.

But the Barclays research suggests the ECB will offer limited additional support going forward.

"We expect the European impulse to wane over time as a driver given the substantial degree to which the ECB is now priced in," says Fiotakis.

"It is worth pointing out that the China impulse is far more important than the European and the US impulse combined," he adds.

Barclays research finds three macro shocks have driven the Euro-Dollar's depreciation from 1.13 to 1.07 over the past three months:

1. A stagflationary shock in Europe from the Ukraine war.

2. A shock to China growth from the Omicron spread amid zero-COVID policies.

3. Resilient US economic activity amid a large tightening of financial conditions.

Above: Decomposing the eur/$ sell-off: March to current. As of 24 May 2022 Source: Bloomberg, Barclays Research.

Their modelling shows that since February the combination of the three shocks justified an overall move from 1.14 to 1.08/1.09 for the Euro-Dollar.

The research finds the China reopening story and associated reduction in risk premium drove the majority of the Euro-Dollar rebound we have seen over recent days.

Market sentiment has been boosted by news of easing restrictions in Shanghai as well as a broader reduction of cases in China more generally.

As such Barclays think China Covid cases and zero-Covid policies will be a significant determinant of the Euro's direction.

Although restrictions are easing in Shanghai the cities vice mayor said last week a return to normal life and the restoration of full factory production was only likely by mid-to-late June.

"While the market may still be positively impressed by the sequential activity improvement, it is also true that part of it is also priced. The risk is that the upside to growth becomes capped should mobility remain contained amid a high persistence of COVID cases in Beijing and other cities," says Fiotakis.