Unipolar disorder: How the euro can benefit from dollar disillusionment

Donald Trump’s unveiling of ‘reciprocal’ tariffs in April caused considerable volatility and delivered a worrying performance in US Treasuries – an asset class which is normally considered ‘safe’.

Questions are being asked about whether his administration’s geo-economic policy set will expedite the transition from the unipolar financial order, at the centre of which has stood the dollar since the Second World War.    

The transition to a new multipolar world will be a long process, but de-dollarisation in FX reserves (US$11.5trn) continued in 2024. What was new was that the euro was the key beneficiary last year.

While data on private sector currency preferences is hard to come by, FX reserve holders’ choices will be watched carefully. Should central banks’ appetite for euros return to what it was in the early 2000s, euro-denominated FX reserves could increase by as much as around EUR450bn.

De-dollarisation is helped by the ‘domestication’ of the UST market, including the exit of key Asian investors. But what does Europe need to do to attract these flows? There will be push-and-pull factors at play here, but at the heart of the story is the need for Europe to provide a high-quality, liquid pool of assets to compete with US Treasuries. Here, more German issuance would help, but it is hard to see how Europe could become a viable alternative to the USD without a European safe asset.

There is more work to do to increase the attractiveness of euro-denominated assets. Think of an EU bond futures market to help them into sovereign indices, a stronger role for the euro in global trade by, for example, euro invoicing of green energy or a wholesale e-€ CBCD. In short, a fully-fledged savings and investments union, formerly known as Capital Markets Union, would be a good sign to ratings agencies and international investors, and could increase international acceptance of the euro.

Official investors are also interested in credit. But the IG EUR market is only one-third the size of the USD market and needs to catch up. We’re going to be keeping a close watch on flows related to USD and EUR-based credit funds for any signs that investors and issuers are redirecting their interest to euro credit products. We also note that the euro remains a strong second in international debt securities market.  

What does this all mean for EUR/USD? While not our base case, we note peak pessimism on US policy could drive EUR/USD into the over-valued region of 1.20/25. But a more sustainable advance, to 1.30+, is going to require some big changes for the eurozone in areas like energy costs or productivity. We’re not there yet.