07:08 AM EST, 03/05/2025 (MT Newswires) -- The US dollar (USD) depreciation momentum could have further to run and while MUFG abandoned its call for EUR/USD to drop below parity, the bank maintains its view that renewed US dollar strength is still likely.

The sheer scale of the move in spreads is a very significant short-term headwind for the US dollar and is of primary importance in influencing foreign exchange at the moment, wrote the bank in a note to clients. The bank highlighted the 10-year yield United States-eurozone spread move versus EUR/USD, highlighting the scope for further EUR/USD gains.

The euro (EUR) was the top-performing G10 currency on Tuesday, helped toward the end of the trading day by the confirmation that Friedrich Merz and the center-right CDU-CSU had agreed on a deal with the center-left SPD to create separate funds in Germany to boost spending on defense and infrastructure, stated MUFG.

For defense, the agreement would mean that any defense spending over 1.0% of gross domestic product, or about 45 billion euros, would be excluded from the calculations for Germany's debt brake -- the constitutional rule limiting the structural deficit to just 0.35% of GDP.

Secondly, a special fund, also excluded from debt brake calculations, of 500 billion euros would be created in order to boost investments in infrastructure over a 10-year period. The agreement also includes the ability of German states to run deficits up to 0.35% of GDP -- currently, states cannot run any budget deficits.

The Greens were not part of the deal and under the numbers of the current parliament will be key in getting this passed. The current parliament can be convened up until March 25. The Greens are staunch supporters of Ukraine in the war against Russia and have argued the need for increased infrastructure spending, so on the face of it, these plans could pass parliament, pointed out the banl.

The far-right AfD will strongly oppose this and remind voters that Merz campaigned against changes to the debt brake, but extraordinary developments in recent days likely provide cover for Merz to justify the action.

But more U.S. tariff action is very likely still coming for Europe, which in MUFG's view, will limit EUR/USD upside from these levels. President Donald Trump, in his address to Congress, was clear that the European Union would be hit with tariffs.

The EU was specifically mentioned along with China, Brazil, India, Mexico and Canada. However, as always with Trump, action remains unclear, added the bank. U.S. Commerce Secretary Howard Lutnick stated before Trump's address that he was considering a deal to ease tariffs on Canada and Mexico as soon as Wednesday.

With U.S. yields rebounding late Tuesday and Trump sounding very aggressive on future tariff action on the EU and others, MUFG is unconvinced that this move higher in EUR will extend much further. Leveraged Funds have been short EUR, but positioning has already been reduced and isn't extreme by historical comparison.