06:05 AM EST, 12/23/2024 (MT Newswires) -- MUFG's view for EUR/USD remains that the euro (EUR) will drop to around the parity level in Q1 of next year before then stabilizing and recovering moderately in the second half of the year.

This is partly based on the macro divergence theme being maintained in the early part of the year before then beginning to fade, wrote the bank in a note to clients. That divergence is quite well priced and so the scope to the downside isn't "huge."

European Central Bank President Christine Lagarde expressed her latest views in an FT podcast released Monday and there was certainly evidence of optimism from Lagarde on the achievement of the 2.0% inflation target, stated MUFG. Lagarde stated that "we are getting very close" to the point when "we have sustainably brought inflation to our medium-tern 2%."

However, reflecting the extent of what is priced in the curve now, there was limited impact in foreign exchange and indeed the Euribor / ESTR futures strip sold off modestly and the two-year bond yield in Germany drifted slightly higher.

There was an element of caution to Lagarde's comments in making her inflation comment "with a little reservation" due to the still high level of service inflation. At close to double the target level, services inflation remains the element that warrants caution and so wage growth and corporate profits need to be monitored closely.

The bank's EUR/USD relative macro view for next year is more about the United States Federal Reserve pausing and admittedly even that is now much better priced following the FOMC meeting last week that signaled a hawkish shift from the committee. The two-year eurozone-US swap rate continues to trade at the lows recorded at the worst point in the divergence pricing in 2022 following Russia's invasion of Ukraine when there were pronounced concerns over deep recession in Europe due to natural gas shortages.

Those concerns never materialized and eventually, EUR/USD rebounded, pointed out the bank.

On this occasion, much of the concern of divergence in growth next year stems from expectations of trade tariffs hitting Europe. MUFG will have to wait until President-elect Donald Trump is in the White House to see how aggressive he is but tariffs hitting the eurozone seems very likely.

Nonetheless, there remains a positive support backdrop for the eurozone as well -- some of the highest nominal wage growth rates in decades at a time when inflation is back close to target points to supportive real wage growth that will help support consumption and the services sector, added the bank. While trade is important, the eurozone as a whole is classed as a large closed economy, just like the US.

The market consensus remains that growth in the eurozone will pick up modestly in 2025. So MUFG sees the scope for a large sustained sell-off in EUR/USD from here as quite limited.