Talk of euro parity with US dollar heats up

Published Wed, Nov 4 20156:40 PM EST

The euro versus the U.S. dollar hitting $1.0843 Wednesday reignited a debate among traders over whether the currency will trade in parity with the dollar before the end of the year. The euro zone currency has been steadily moving down on European Central Bank President Mario Draghi 's dovish commentary. Wednesday, the euro reacted to hawkish comments from Fed Chair Janet Yellen , suggesting a U.S. central bank rate hike could come in December. Over the summer, the Fed cited international developments — particularly weakness in emerging markets and China — as a concern. But the story has changed over the past month with China cutting rates and Europe suggesting it may ease further. "It seemed like a coordinated response from Europe and China to ease monetary policy while the U.S. tightens," said Duncan Wrigley at NSBO Bank. Given the recent stabilization in the emerging market story and Europe taking a proactive approach to addressing its economic headwinds, some economists think the Federal Reserve is moving toward liftoff. So what does that mean for the euro/dollar pair? If the Fed continues to flood the market with hawkish statements followed by a potential rate rise in December, traders say the euro will definitely head lower. "With QE2 and the Fed hike it [the euro] could go lower than 1.06," said Alberto Gallo at RBS. Policy divergence is likely to be a stronger theme as we approach the final weeks of the year. Read More Santoli: October's market rally settled nothing "The market is seeing monetary divergence play out: Yellen's statement coupled with a very dovish Draghi," said David Owen, economist at Jefferies. And the divergence trade may continue until the end of the year, as the two most powerful central banks look to contrasting policies to bolster their respective economies. "People have started to embrace the idea of divergence. We talked about it all year, now it's starting to play out," said George Goncalves, head of U.S. rates strategy for fixed income at Nomura Holdings. There is now mounting pressure on Draghi to deliver the goods and expand quantitative easing before the end of the year. "Both the Fed and the ECB are going diabolically in different locations. If Europe doesn't give the market what it wants, it could create unnecessary volatility," said Goncalves. Traders betting on "Super Mario" have been building short positions in the euro. Wednesday, the common currency hit its lowest level against the dollar since July 21, 2015. And that's a big win for the ECB. The exchange rate has been seen by economists as a powerful tool for the ECB. "The central bank would drive down the euro to parity if it could," said Owen. Read More Dan Loeb's two favorite long-term stock ideas Jefferies points out that the euro/dollar exchange rate is much more important to Europe than it is to the U.S. or Japan given that it's much more reliant on trade. In fact, it imports a higher share of its GDP outside the euro zone. "So if you want inflation to go up, the exchange rate is one way to do it," mentioned Owen. Market participants say a weaker euro and a supportive central bank is good for European stocks. Deutsche Bank wrote that it sees 10 percent upside for EU stocks by the end of 2016. Their bull case? Stronger-than-expected ECB action further pushing down real bond yields and the euro. "We expected euro-area real bond yields to remain low, European growth momentum to be robust and European macro uncertainty to decline further as the Euro-area continues to recover," wrote Sebastian Raedler, head of European equity strategy at Deutsche Bank.

Aris Messinis | AFP | Getty Images

The euro versus the U.S. dollar hitting $1.0843 Wednesday reignited a debate among traders over whether the currency will trade in parity with the dollar before the end of the year.

The euro zone currency has been steadily moving down on European Central Bank President Mario Draghi's dovish commentary. Wednesday, the euro reacted to hawkish comments from Fed Chair Janet Yellen, suggesting a U.S. central bank rate hike could come in December.

Over the summer, the Fed cited international developments — particularly weakness in emerging markets and China — as a concern. But the story has changed over the past month with China cutting rates and Europe suggesting it may ease further.

"It seemed like a coordinated response from Europe and China to ease monetary policy while the U.S. tightens," said Duncan Wrigley at NSBO Bank.

Given the recent stabilization in the emerging market story and Europe taking a proactive approach to addressing its economic headwinds, some economists think the Federal Reserve is moving toward liftoff.

So what does that mean for the euro/dollar pair?