The Dollar and the Euro: On a Path to Parity?

Why we think it could take longer than expected, with better entry points still to come.

We think the dollar is likely to strengthen over the coming year, and the euro is likely to weaken. The trouble is, so does almost everyone else—and crowded trades can be uncomfortable.

That is why we think investors should remain moderate in their dollar risk right now. The euro may be on a path to parity, but it could take longer than expected and be a volatile ride, with better entry points still to come. On the margins of probability but not to be dismissed, it could end up on a different path altogether.

Tariffs

Friday’s preliminary Purchasing Managers’ Index (PMI) data, the first since the U.S. election, confirmed an established trend: The U.S. economy is performing much more strongly than Europe’s.

This looks set to continue, partly because there is little immediate prospect of a meaningful stimulus in either Europe or China (Europe’s main source of external demand), and partly because of the anticipated trade policies of the incoming U.S. government.

It may be some time before we know the final shape and scope of U.S. tariffs, but we do know that the uncertainty alone can suppress business activity in economies that are potential targets. We also know that the dollar appreciated last time Donald Trump was elected president, and appreciated again, by 11%, when he imposed tariffs on China.

Although the main target of tariffs is likely to be China once more, Europe could also be the more exposed. Tariffs are expected on European exports to the U.S., but at the same time its manufacturing sector could see more competition as China tries to redirect some of its lost U.S. exports. A trade deal between the U.S. and the European Union may help, but if it includes ramped-up purchases of U.S. natural gas, buying the dollars to pay for that gas would add more downward pressure on the euro.

These diverging economic fortunes are playing out in interest rate markets. U.S. rates are priced to be 1.5 – 2.0% higher than eurozone rates throughout the coming rate-cutting cycle, as U.S. Federal Reserve officials worry about stubborn inflation while their counterparts at the European Central Bank increasingly fret about growth. That, in turn, is attracting capital to the dollar. In 2014, a similar divergence in rates fueled a 25% rise in the dollar.

Stimulus

What makes us cautious on this view?

In the immediate term, it’s the current level. At 1.04, the euro has already gone a good way along the path to parity. The market is still significantly long the dollar in response to the U.S. election result. On almost any standard valuation metric, such as purchasing power parity, for example, the dollar looks expensive. It also looks stretched given that the eurozone’s current account surplus generates structural demand for euros. And in eight of the past 10 years, the dollar has gone down in December (although one of the exceptions was 2016, after Trump’s last election victory).

Medium term, companies may respond to the uncertainty around tariffs by bringing forward orders, triggering a “fake” cyclical boom in Europe. In addition, China may surprise the market with stimulus aimed at boosting rather than merely stabilizing its economy; that looks unlikely for now, and a domestic focus may limit the effect on Europe, but it remains a possibility.

The run-up to Germany’s election in February also poses risks to the dollar at current levels. The last coalition collapsed due to fierce debates about the country’s fiscal constraints. The next government probably won’t command a majority big enough to override Germany’s “debt brake,” but the election does look likely to punish the fiscal hawks. Parsing the statements of Friedrich Merz, the Christian Democrat who is favored to become chancellor, could be critical for currency strategists over the next three months.

In the background lies Ukraine. As last week’s events suggest, this geopolitical risk is set to rise over the coming weeks as both sides in the conflict seek to maximize their advantage ahead of potential negotiations once Trump is in office. That arguably favors the dollar. But if peace is achieved and money is raised for reconstruction—perhaps even via a common eurozone bond issuance, just as Germany gets a more fiscally dovish government—that would be a powerful stimulus for Europe’s construction and manufacturing industries. This outcome is on the margins of probability now, but it should not be dismissed, in our view.

On the dollar side of the equation is the risk that the new U.S. administration attempts to augment its tariffs with efforts to weaken the currency, as well as the gravitational pull of the U.S. budget deficit. We see U.S. debt sustainability as an issue for 2026 rather than 2025, but government funding debates could provide a flashpoint early in President Trump’s tenure.

Too Solid a Consensus

Is the U.S. growth outlook positive? We think so. Is Europe facing formidable cyclical, structural, political and geopolitical challenges? For sure. Will this play out in the currency market? In all likelihood, yes.

But there are considerable risks to this view, which may have become too solid a consensus. If the euro does go to parity with the dollar, it’s unlikely to be a straight line and the volatility could be especially acute over the next three months.