The euro`s rise above $1.20 this week has prompted talk that it is becoming a safe haven for investors, posing a problem for the European Central Bank as it plans to roll back its huge economic stimulus in the coming months.
Many remain sceptical that a currency which has undergone ordeals such as the Greek debt crisis in recent years can join the Swiss franc as a place to store money in times of market stress.
Nevertheless, the euro has remained strong against the dollar in the past two weeks despite concerns about a standoff between the United States and North Korea which have sent spasms of selling through global stock markets.
Add in a series of high-level departures from the U.S. administration and President Donald Trump`s failure so far to get his plans for corporate tax cuts and big infrastructure spending through Congress, and some investors are reassessing their attitude towards the single currency.
"Disappointment about U.S. reflation and disarray in the White House have enhanced the relative attraction of the euro to the extent that a discussion around its safe-haven credentials has opened up," said Jane Foley, senior FX strategist at Rabobank in London.
In recent years, investors` appetite for risk and the euro`s value have largely moved in tandem. Particularly during flare-ups in the euro zone debt crisis in 2011 and 2013, a selloff in equities or emerging market debt would drag the euro lower.
But now the euro seems to be gathering momentum. If the currency sheds its role as a proxy for risk appetite, ECB policymakers who meet next week will have to factor in its economic impact.
In particular they will be wary of a strong euro hurting exporters and undermining their efforts to push low inflation back up to the ECB`s target, just as they are preparing to start winding down a 2 trillion euro ($2.4 trillion) plus bond-purchase programme.
The euro is still far from an undisputed safe haven, with memories of the debt crisis fresh and policymakers struggling to push wage growth higher. However, its near 14 percent rise versus the dollar this year has led investors to note its structural strengths.
Consensus forecasts for euro zone and U.S. economic growth in 2017 are both around 2 percent. But while the European forecast has been revised up since the start of the year, the U.S. figure has been roughly halved. On top of the that, the euro zone`s current account surplus is growing.
Net inflows into European equity mutual funds have totalled 23.4 billion euros since May compared with net outflows from U.S. counterparts of about 24 billion euros, according to Thomson Reuters Lipper data.
Speculators` long positions in the euro are at their biggest in five years while some of the world`s largest bond investors are buying European debt, betting that the strong currency will delay the ECB plans to roll back stimulus.
The single currency hit a fresh 2-1/2 year high above $1.20 on Tuesday after ECB President Mario Draghi made no mention of the currency`s strength at a central bank conference in Jackson Hole last week. At the same time, 10-day correlations between the index, a measure of risk appetite, and the euro approached their lowest levels of this year.
The euro traded around $1.1850 on Thursday.
"The breakdown in correlation between risk appetite and the euro is because the general outlook for the euro zone looks less bad," said Rory McPherson, head of investment strategy at Psigma Investment Management. The euro`s relative undervaluation on a trade-weighted basis was boosting its value, he added.
On many banks` internal models, the euro is still considered relatively undervalued on a purchasing parity basis by between 5 and 10 percent against a trade-weighted basket of currencies. FADING DOLLAR
Still, the inflows from equity fund managers or hedge funds haven`t impressed global central banks or large pension funds which remain broadly underweight the euro in their holdings.
Data for the quarter ending March from the International Monetary Fund show euro assets have broadly stagnated around 16 percent of global currency reserves, compared with those in dollars which have topped 60 percent in the last four quarters.
But the breakdown in correlations between risk and the euro is a big attraction in itself for those investors who favour assets that are relatively immune to market swings and who have so far been cautious about the euro`s outlook.
"Most institutional investors remain underweight (euro assets) and many currency investors have been trying to time the top of the euro rally in the last few months, indicating the level of scepticism that still persists in the market," said James Binny, head of currency for EMEA at State Street Global Advisors in London.
Recent Reuters equity polls have highlighted the long-term scepticism among banks and strategy desks, with analysts` forecasts consistently undershooting market prices.
The euro`s strength also indicates the headwinds for the U.S. economy and currency as markets have reduced their expectations of Federal Reserve interest rate increases this year, a major support for the dollar.
"Since the start of the year, we have been trimming our growth forecasts for the U.S. while the momentum is behind the euro zone economy," said Stephen Gallo, European head of FX strategy at BMO Financial Group in London.LINE IN THE SAND
But the euro`s rise will raise some concerns among ECB policymakers which may be mentioned at the next Governing Council meeting on Sept. 7.
While the currency`s strength received only a passing mention in minutes of their July meeting, analysts say it will play a prominent role during discussions this time.
Rapid gains by the euro are worrying a growing number of ECB policymakers, raising the chance that its asset purchases will be phased out only slowly, three sources familiar with discussions told Reuters.
The ECB did not comment for this article.
"The ECB is in a delicate situation as it will have to pull a rabbit out of its hat to slow the euro rally and merely talking down the currency won`t help," said Thomas Flury, global head of currency strategy at UBS Group AG.
($1 = 0.8438 euros)
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