Highlights:

• The USD is a countercyclical currency, usually benefitting from global growth weakness and financial stress.
• Yet barring a severe escalation of banking woes, we expect a weaker dollar and a higher EUR/USD by year-end.
• The Fed is likely done with its rate hikes as tighter credit conditions kick in and a recession is looming. A pivot as soon as in Q4 will mean that yield gaps vs. the euro area will tighten, a EUR positive.
• With central banks reaching peak rates and inflation (sluggishly) easing, yield volatility is set to recede, removing a key pillar that drove the USD further into overvaluation in 2022. By contrast, the EUR will benefit from resuming capital inflows, a fading terms of trade shock, and the ECB’s more persistent hawkish tilt.
• The main risk to our constructive EUR/USD view is the tail risk of a very severe escalation of the banking crisis, with safe-haven flows dwarfing other FX drivers. Should euro area bank stress rise materially and revive the bank-sovereign doom loop, the EUR would suffer more materially.

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