IN a year dominated by sterling’s decline, the yen’s rise and the dollar’s weakness, little impression has been made by the euro — although that may be about to change.

The foreign exchange sidelines are not a bad place to be. The pound’s sharp fall illustrates investors’ doubts about post-Brexit Britain. Japan is on a permanent state of yen-watch, putting continuous pressure on its central bank to act. The Federal Reserve agonises whether a rate rise strengthens the dollar to the extent that it weakens the US economy.

Away from the fray, the euro is quietly strengthening. The year began with the euro worth about $1.08 and market positions heavily shorting the currency.

Since then, the market has been paring back those short positions and the euro is now worth about $1.13.

True, it is not a vast appreciation compared with the yen’s rise against the dollar and the euro is below its $1.16 high for the year reached in May, but analysts and investors think the euro is on a more sustainable upward path.

Lack of political risk, a strong current account surplus and robust data help lift torpor

“For many people, the euro has been showing surprising resilience,” says Dominic Bunning, HSBC’s senior FX strategist.

“Many have a perception that the euro is going to parity with the dollar. We think the euro is going to parity, but it’s going to parity with the pound in the long term.”

There are several reasons to explain the euro coming back into favour. First, the current account surplus of the eurozone, like Japan’s, is strong, generating inflows to the region. It now adds up to 3.3pc of gross domestic product.

“There is no doubt the current account surplus in both areas are significant and continue to prop up both currencies,” says Alan Wilde, head of fixed income at Baring Asset Management.

Secondly, political risk, a factor that has tended to weigh on the euro, seems to have been kept at bay. Brexit was meant to raise questions about the euro’s survival, but since the UK is not a euro member and as there are few signs of a feared Brexit contagion, those questions seem redundant.

Thirdly, eurozone data have been fairly robust. The region’s business output has hit a seven-month high, enough to make JPMorgan drop expectations of further European Central Bank rate cuts, while the rate of growth on a year-on-year basis has overtaken that of the US for the first time in five years.

Dollar weakness is another factor pushing the euro higher, influenced by fluctuating US economic data.

As the market awaits Fed chair Janet Yellen’s speech from its annual symposium at Jackson Hole last Friday, market expectations that she will continue to walk the cautious route she has pursued for much of the year should keep the dollar down, and so support the euro.

Even if the Fed chair forks off down a hawkish road, it is not the euro that will fall significantly against the dollar but other currencies such as the pound, the yen and the New Zealand dollar, says Goldman Sachs.

That is because the market has become ‘less interested’ in the policy divergence theme, it adds.

UBS concurs. “Two-year rate differentials between the US and the euro area are now close to their widest of the cycle, yet EUR/USD is well off its lows,” it says in a note. What matters more to investors, adds the bank, is growth differentials.

Is euro appreciation likely to match the pace of the yen’s rise? There are specific reasons for the yen’s strength, says Mr Wilde, such as market scepticism about the Bank of Japan’s negative interest rates policy and Japanese investors repatriating the currency after being encouraged to move assets overseas.

Ugo Lancioni, FX and fixed income portfolio manager at Neuberger Berman, says the yen’s strength is “simply a function of its excessive devaluation” of recent years.

Neither the BoJ nor the ECB want to take action at next month’s meetings, Mr Wilde says, so for the time being euro resilience may be enough for the ECB to conclude that its monetary policy is working.

“Stability is probably more important to central banks than volatility,” Mr Wilde says.

Published in Dawn, Business & Finance weekly, August 29th, 2016