Markets have reacted to these developments and over the last few weeks began to price in a stronger Euro alongside higher probabilities of a Ukraine peace deal (Exhibit 1). The European economy remains under pressure, but our economists see potential upside to European growth from these developments, though the scope varies.
Exhibit 1: Markets have priced a stronger Euro alongside higher probabilities of a Ukraine peace deal
The most important channel for European growth from a ceasefire is via natural gas prices. Following the invasion, gas prices spiked, and the Euro area current account deteriorated sharply, putting significant pressure on the Euro (Exhibit 2). While the issue is complex, our economists have considered several possible peace deal scenarios. In a limited ceasefire scenario, where gas flows return to their 2023-2024 average, our economists see a boost to Euro area GDP of 0.2% over the next year.
Whereas in an upside scenario where gas flows return to pre-war levels, they estimate a 0.5% boost to growth. Altogether, the analysis points to modest European growth upside from a ceasefire, unless a comprehensive peace agreement, and normalized gas flows, can be reached. However, we note that the Euro area trade balance has mostly recovered to pre-invasion levels in aggregate due in part to shifting energy trade partners and the weaker Euro. As a result, we estimate that the Euro is roughly fair on a trade-weighted basis, and we do not think fair value would change dramatically even in the event of a cease fire deal.
Exhibit 2: The EA current account has normalized, supported by lower energy prices, shifting energy trade
partners, and a weaker Euro
Similarly, this weekend’s German election results present modest growth upside for the Euro area. Debt brake reform will be the key determinant of any growth improvement in the region, and our economists now expect a limited reform that will turn fiscal policy modestly more expansionary in Germany this year. More importantly, our economists now expect defense spending to rise to 2.5% of GDP over the next 2-3 years across the Euro area. Taken together, they have made minimal changes to their 2025 forecasts but have lifted their Euro area growth forecasts by 0.1pp in 2026 and 0.2pp in 2027. Further upside is still possible if Germany makes room for an even more substantial spending increase.
The positive growth impulses from these scenarios suggest a modest boost to EUR/USD if they are realized. Using our rule of thumb that a 1pp increase in year-ahead growth expectations typically leads to a 1.5% increase in EUR/USD, we find that Euro could strengthen by about 1% on our economists’ upside scenario for a resolution in Ukraine (Exhibit 3). These estimates are positive though relatively small, given the modest size of the growth impulses. It is also important to note that our estimates focus on the typical Euro response to changes in the outlook over the next year. It is possible the market could find further upside if policy changes are interpreted as a more lasting growth impulse, though we caution that this would be atypical. Still, the prospect of a structural shift in EU defense funding could be prompting the market to give more credit to longer-term developments than is typical.
Exhibit 3: Euro could strengthen by about 1% on a resolution in Ukraine, and more modestly on German debt brake
At the same time, it is important to keep in mind that our economists still anticipate tariffs on at least some European goods, underscoring our more negative outlook for growth this year. The changes providing the positive impulse discussed above are at least in part a response to shifting US policies, and to some degree the “other shoe” has not dropped yet. If tariffs weigh more heavily on European growth, EUR/USD could weaken further. If expectations were to converge to our economists’ Euro area growth forecast for the next year, we could see up to 1% of downside to EUR/USD (despite the upgrades, our forecasts remain below consensus), setting the direct impact of tariffs on the currency aside. So far, European growth has been relatively resilient compared to expectations despite trade policy uncertainty. But we don’t rule out the direct impact of potential tariffs on FX or growth. We have estimated that reciprocal tariffs would likely see a small negative impact for the Euro, assuming they do not account for value-added taxes and are not a replacement for larger tariff scenarios that the market may be anticipating. And our other work estimates substantial impacts on the Euro from broader tariffs.
We think rising optimism for a quick fix to Europe looks overdone for now. While some of the initial hurdles have been cleared, we see a long road ahead for the type of shifting policy mix that would be required to meaningfully lift the Euro. Markets have closed much of the undervaluation gap in the Euro this year, reflecting lower tariff risk perceptions (Exhibit 4). However, we think that there are still challenges ahead, and rising upside risks from increased fiscal spending are to some extent a reflection of shifting US policies that also pose important downside risks.
Exhibit 4: Much of the undervaluation gap in the Euro has closed, reflecting lower tariff risk perceptions
This is why we think the current equilibrium for the Euro looks unstable. Markets continue to price only a small tariff premium in the currency, and we think their implementation will ultimately take the cross back lower. At the same time, if tariff policy changes are smaller than markets expect—perhaps in part due to pro-active EU policies—then the currency could rise further. Recent changes have already raised the risks around our forecast for more substantial depreciation. Despite the lingering uncertainty and “fat tails,” implied volatility in EUR/USD has declined since the start of the year. While it may take some time to realize these tails, long vol expressions still screen as an inexpensive way to position for a more stable equilibrium in the currency.
