The Euro will probably extend its rally as inflows from global investors chasing the economic recovery rise, says analysis from French lender Crédit Agricole.

There are two main drivers are behind the Euro's 10% rise in 2017, according to new research on the currency issued by analysts at Crédit Agricole: the first is demand from foreign investors who want to buy European stocks and shares, and the second is demand from traders taking bets that the Euro will strengthen, in the speculative market.

What is more, these twin drivers of Euro appreciation are set to continue - especially demand for Eurozone stocks and shares as the European economic recovery helps support Eurozone stock markets.

Demand from speculators may be less of a driver going forward due to the already crowded Euro-longs, 'longs' meaning bets the Euro will go higher.

However, that said, the Euro is still dramatically 'undervalued', compared to alternative valuation models and this could still draw more supporters (see chart below).

Valuation models are used by analysts to calculated a 'fair-value' which an asset's market value can be compared with.

The models take into account fundamental variables which influence the exchange rate such as the trade balance and inflation.

The market value can then be compared to the computed fair value and if the market price is below fair value the asset is said to be undervalued; and vice versa if it is above.

The expectation is then that the market price will 'catch up' with the fair value, and this knowledge helps analysts forecast the direction of the next price movement.

Currently, the Euro's market value is below that of the two model valuations to which it is compared - VALFex and PPP, suggesting it is undervalued and likely to rise.

"The EUR undervaluation should continue to make it an attractive long," says Head of G10 FX Strategy at Crédit Agricole, Valentine Marinov.

Central Bank Demand

But the Euro could derive strength from another source - increased demand from central banks, who hold reserves of Euros as a matter of course, but who reduced them during the Eurozone debt crisis of 2011-2012.

Marinov thinks central banks could return and purchase Eurozone stocks and shares as a way of increasing their Eurozone assets rather than simply increase cash reserves - but it amounts to the same thing from the perspective of demand for the Euro.

"In addition, the EUR’s share of central bank FX reserves remains depressed by historical standards and we expect central banks to continue to rebuild their exposure to the EUR by focusing on investments in stocks for the time being," says the Credit Agricole analyst.

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Reduced Borrowing

One final further source of potential upside for the Euro is from a slow-down in Euro-borrowing for use in what is called the 'carry-trade'.

The carry-trade is a risk-free method of speculating in the currency markets by which investors borrow a sum of money in a currency of a low interest rate jurisdiction such as the Euro or Yen, where interest rates are close to 0.00% and -0.10% respectively, and invest that money in the currency of a higher interest rate jurisdiction, such as the Australian or New Zealand Dollar, where interest rates are between about 1.5% and 1.75% respectively.

The interest they make on the investment (1.5-1.75%) is higher than the interest they have to repay on the loan (0.00% or -0.10%), resulting in a net 'arbitraged' profit.

The risk is that the investment currency weakens, of course, but this can be offset at a relatively small fee with a hedge.

Interest rates have been kept extraordinarily low in the Eurozone in order to stimulate growth, as it makes borrowing for businesses and individuals cheaper, leading to more spending and growth, but now that the region is recovering out of its crisis, the European Central Bank (ECB), who are in charge of setting interest rates, may increase them.

This will have the effect of closing the profit gap on the carry-trade and will result in fewer outflows of borrowed Euro's from the Euro-area, reducing Euro-selling - or 'supply' - in the process.

Some carry traders prefer to invest in interest rate bearing foreign debt instruments for the purposes of making carry, and the chart below shows that the Euro is still subject to large outflows from funding these carry-trade transactions, however, if the ECB continues to tighten its monetary policy - which means raise interest rates one way or another - there is much scope for it to rebalance.