【MACRO Insight】 European fiscal transformation under the global economy and geopolitics ! Will the U

The euro rose to its highest level against the dollar since December as Europe plans to significantly increase defense spending, and analysts withdrew their expectations that the currency pair would fall to parity this year. A large amount of money has poured into the European defense industry, causing analysts to abandon their predictions that the euro will fall to parity with the dollar. The euro rose as much as 0.7% against the dollar on Tuesday, reaching a high of 1.0559, the highest level since December last year, and up about 4% from a two-year low a month ago.

European fiscal policy has taken a historic turn in recent weeks as Trump made it clear that Europe cannot rely on the United States for its defense, negotiated directly with Russia to end the conflict with Ukraine, and publicly fell out with Ukrainian President Volodymyr Zelensky. The fact that Germany is ready to increase defense spending will serve as a special shield for the euro against the dollar to avoid falling to parity, according to Deutsche Bank. In the options market, risk reversals on the euro against the dollar over the next six to 12 months show that traders have become less bearish on the euro since November last year. The latest CFTC data shows that bearish sentiment has softened as investors cut bets on a weaker euro since the beginning of the year, which reached the highest level in more than three years in December last year.

Goldman Sachs believes that tariffs remain the “pillar” of the euro's outlook. Goldman Sachs now expects the euro to trade around 1.01 against the dollar in six months, lower than the current level, but stronger than the previous forecast of 0.97. Mitsubishi UFJ Financial Group believes that Trump is more likely to impose tariffs on European goods in the second quarter than in the first quarter. The bank now expects the euro to trade around 1.02 against the dollar by the end of this month, compared with a previous forecast of a drop to 0.99.

George Saravelos, global head of foreign exchange research at Deutsche Bank, warned that the relationship between the global economy and geopolitics is undergoing a seismic shift, and it cannot be overstated. However, despite the rising risk of a global recession, the dollar, as a safe-haven currency, has not strengthened significantly.

Trump's announcement of a suspension of military aid to Ukraine and 25% tariffs on Canada and Mexico has shaken two of the United States' global pillars: security guarantees to Europe and respect for rules-based free trade. About half of U.S. imports now face tariffs of more than 20%, with the average tariff rate exceeding 10%, the highest level since 1970. Deutsche Bank stands by its conclusion that this marks the biggest shift in global trade relations since the collapse of the Bretton Woods system.

It is also certain that the geopolitical backdrop in Europe is more volatile than it was a month ago. But why is the dollar weakening？

Deutsche Bank points out that there are two mutually reinforcing themes that have been building in recent weeks. One is the tightening of the US fiscal stance and the broad rise in US uncertainty. Deutsche Bank has long argued that tariffs are just a tax and therefore represent fiscal tightening, with bullish implications for fixed income and (ultimately) growth for the Fed and the rest of the world. The key to offsetting the impact of US tariffs has always been to spend money/cut taxes elsewhere. But so far, the signals from the US government and Congress have been leaning towards a more conservative fiscal stance, to which these tariffs are attached.

Second, high-beta and low-beta currencies have performed well at the same time, and the common point is that they are cheaply valued relative to the dollar. Third, over the past 30 years, despite the high level of global uncertainty, the valuation of US risk assets has lagged significantly relative to the rest of the world; fourth, the US current account deficit has exceeded the 4% threshold in recent months, which historically marks the limit of the dollars overvaluation.

To sum up, Deutsche Bank is starting to be more open to a broader dollar weakness. There are several things that could hinder Deutsche Bank's thinking: one is the changing news flow in the United States and the prospect of at least a partial reversal of fiscal policy given the possible damage to the US economy; the Fed's reluctance to ease policy in an environment where tariffs will put upward pressure on prices; and the broader knock-on effects of tariffs and geopolitical developments on the rest of the world, which pose serious downside risks to its growth and will prompt a more dovish global response. Deutsche Bank's view on the dollar remains neutral for now, but the key message is that Deutsche Bank is more open to the two-way risks facing the dollar.