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The Euro to Dollar exchange rate (EUR/USD) has peaked and will likely trend lower over a three-month horizon, before rebounding strongly over the 12-month horizon.

This is according to a new forecast and analysis from Scandinavian lender DNB Bank that finds the market is underestimating how long the Federal Reserve will keep interest rates elevated.

"EUR/USD has risen recently due to the sharp drop in USD interest rates," says Ingvild Borgen, a market analyst at DNB Bank ASA. "We expect USD interest rates to rebound near-term."

The focus on relative interest rates in the Eurozone and U.S. confirms this to be a key driver of the Euro-Dollar exchange rate, in DNB's assessment.

"As EUR-USD interest rate spreads appear to be the dominant driver of EUR/USD currently, we expect EUR/USD to drop slightly from current levels," says Borgen.

The Euro this week reached a new 13-month high at 1.1095 as investors continue to back a bet that the European Central Bank (ECB) will 'out hike' the Federal Reserve over the coming months.

The Fed is meanwhile expected to begin cutting rates in the second half of 2023 as policymakers respond to an economic slowdown, whereas the ECB is tipped to only begin such cuts in 2024.

This divergence in central bank policy has supported Eurozone bond yields to a greater degree than their U.S. equivalent, creating a capital flow in favour of the Euro.

But, how long can this theme remain intact?

For DNB, the longer-term picture is one in which further Euro gains can be realised as the Eurozone economy outperforms, but as always with financial markets, nothing moves in a straight line.

"Our forecast from January was for EUR/USD to trade at 1.10 in three months and 1.20 in 12 months. Three months later, EUR/USD has reached the expected level, but we do not expect the path towards 1.20 to continue uninterrupted from here," says Borgen.

DNB tells its clients of its markets division that downside risks for the Euro-Dollar dominate the near term, and it adjusts its 3-month forecast down, from 1.10 to 1.07.

"The reason for our forecast reduction is that EUR/USD interest rate spreads appear to have become the key driver of EUR/USD, and we expect USD interest rates to rebound relative to EUR interest rates near-term," says Borgen.

The Dollar's recent decline in value is linked by analysts to the stress in the U.S. mid-tier banking sector, centred around the collapse of Silicon Valley Bank in March.

This has tightened lending conditions across the banking sector and led investors to bet the Federal Reserve could afford to both end its rate hiking cycle and consider the timing of interest rate cuts.

But, "we do not believe the banking sector turmoil warrants rate cuts from the Federal Reserve (Fed) as soon and as fast as market pricing currently suggests," says Borgen.

DNB's U.S. economist reckons the market's pricing for the Federal Funds target rate is too low and a rebound in USD interest rates in the coming three months can be expected.

Longer-term, however, improving eurozone growth and a diminishing USD rate advantage suggest EURUSD should continue to rise towards 1.20.

Downside risk in EURUSD – 3-month forecast adjusted down from 1.10 to 1.07

The ECB is meanwhile expected to raise interest rates further over the coming months, but crucially, this is well understood by the market now.

"The upshot is that we believe there is more upside risk in USD interest rates near-term, and that the EUR-USD interest rate spread should thus fall," says Borgen.

However, DNB forecasts EUR/USD to rise in the second half of this year and early next year.

"The reason for this is that we believe US growth is set to drop significantly relative to eurozone growth in the coming two years," says Borgen.

In 2024, economists at the bank expect growth of 0.3% year-on-year in the U.S., but 1.2% year-on-year in the Eurozone.

"Due to this, we also believe the large spreads of US interest rates relative to eurozone interest rates, which have persisted for the better part of the last decade, are about to come down," says Borgen.

"We are confident EURUSD will continue to move towards its long-term average level, of 1.20, in 12 months. We thus maintain our 12-month forecast of 1.20 from January," he adds.