Bank of America forecasts euro appreciation due to diverging U.S. and EU economic policies and reforms

    by VT Markets
    /
    Mar 28, 2025

    The euro is projected to strengthen considerably over the next two years, as Bank of America anticipates different economic and policy trends in the U.S. and eurozone. The bank forecasts the euro to hit $1.15 against the U.S. dollar by the end of 2025, increasing to $1.20 by the end of 2026.

    Two main factors are expected to drive this change: possible stagflation risks in the U.S. if a second Trump administration occurs, and an evolving fiscal policy in Europe. BofA suggests that renewed tariffs and fiscal tightening may hinder U.S. growth while maintaining inflation.

    Europe Fiscal Policy Outlook

    In contrast, Europe’s outlook appears more favourable. There are indications of a shift in Germany’s cautious fiscal position, with greater public investment and defence spending anticipated to bolster growth across the eurozone. These reforms, coupled with EU-level fiscal coordination, could enhance the region’s economic resilience.

    The earlier passage outlines differing macroeconomic paths in the United States and the eurozone that are projected to influence currency dynamics over the next two years. Analysts expect the euro to climb to $1.15 and eventually reach $1.20 per dollar by the end of 2026. What’s driving this is a divergence in fiscal decisions and inflation prospects on either side of the Atlantic.

    In simple terms, we might be looking at a combination of subdued growth and persistent consumer prices in the U.S.—a scenario some would regard as stagflation risks—especially if there are large policy shifts under a potential administration change. Tariff impositions and spending constraints may together stall stronger expansion without cooling prices, which is a historically problematic mix for currency strength or stock performance.

    Strategic Market Implications

    On the other hand, eurozone countries, particularly Germany, seem to be moving away from tight budgetary policy towards bigger public investment programmes. Berlin’s increased emphasis on defence and infrastructure outlays could not only stimulate activity within Germany, but also produce flow-on effects to partnered economies within the bloc. Brussels’ moves towards tighter fiscal synchronisation across members may provide added consistency in regional decision-making, reducing downside shocks and supporting expectations of higher medium-term returns.

    From a practical viewpoint, it’s worth keeping close attention on upcoming central bank minutes and budget announcements from key European capitals. These will be the sort of signals we’ll want to assess week-by-week when mapping any moves in currency positions. If headline inflation in the U.S. fails to fall despite sharper interest rate paths, yield differentials may no longer work in the dollar’s favour.

    We are watching interest-rate futures and two-year bond spreads for concrete signs that this turn is beginning to embed. If we do see euro strength start to reflect in these shorter-term instruments, it could reinforce option vols and bias a stronger forward curve. Positioning along the forward curve, particularly in structures with asymmetric payoffs, may offer better protection through what are likely to be unpredictable economic developments.

    We find that expression through euro call spreads, especially those struck slightly out of the money for six-month to one-year tenor, offers solid convexity without excessive upfront premium. Managing gamma risk around key event weeks will still be critical. For instance, a shift by Frankfurt or a key budget announcement by Berlin could move implied vols beyond current pricing.

    Jackson’s work on comparative policy differentials last quarter suggested waiting for fiscal signals to confirm the eurozone’s path—those endorsements may be arriving sooner than expected. Mehta’s review of long-term dollar cycles adds context: periods of tightening combined with flattening trade balances have tended to weaken the dollar, especially when other blocs show improved coordination.

    As things develop, we remain on the lookout for dislocations between fundamentals and positioning. Should short dollar positioning accelerate too fast without fresh data support, we may consider tactical countertrend trades, particularly around key CPI or employment releases. Awareness of risks tied to U.S. fiscal brinkmanship is also warranted, especially if another round of debt ceiling debates hits the headlines. That has often driven temporary haven demand for U.S. assets, but not consistently so, depending on political heat at the time.

    We stay focused, data-driven, and ready to rebalance exposures as this shift plays out.

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