The euro moved sideways because it was at the mercy of politics. Part of the market appears to be concerned about the risk that there will be no agreement between Greece and Europe. We remain confident that there will be a deal eventually. The US dollar rally came to a stand-still. But this is only temporary in our view. Strong fundamentals and higher US rates this year and next year should push the US dollar higher across the board.
Euro at the mercy of politics
The euro lacked any direction this week. This was mainly because eurozone politics took the scene again. As a result, the euro reacted on comments from eurozone officials. At the time of writing there was no agreement between Greece and Europe and therefore the euro was unchanged for the week. However, below the surface currency markets appeared to be more nervous. The FX option market showed a substantial increase in demand to protect the downside in EUR/USD in the near term. This could be a signal that some investors are worried that an agreement between Europe and Greece may not be reached. Other financial markets did not signal such cautiousness. This signals that financial markets don’t appear to be very concerned about contagion.
US dollar rally stalled for now…
The US dollar Index rose by around 17% in the period July 2014 to mid-January 2015. Since then the rally has lost momentum. This is rather surprising because the ECB and other major central banks eased monetary policy further and the strong US employment report has pushed US yields higher. So why has the US dollar not strengthened further? For starters, sentiment towards the eurozone has improved. This has been driven by stronger than expected eurozone economic data and optimism that Greece and Europe
will eventually come to an agreement. Moreover, there has been doubt about the Bank of Japan’s stance about a further weakening of the yen. Last but not least, US economic data –apart from US employment report – have been somewhat weaker. Financial markets continue to be reluctant to price in the rate hikes that the US Fed is currently signaling. Next week, Fed Chair Yellen will testify to the Senate and to the House. It is likely that she will sound somewhat more hawkish than the recent dovish FOMC minutes. If this is the case, there could be a sharp upward adjustment in US interest rate expectations and a restart of the US dollar rally. In addition, US CPI and fourth quarter GDP (second estimate) will be closely eyed.
…but we expect a resumption soon
The recent loss of momentum in the US dollar rally is just a pause in our view. First, US assets remain very attractive, because of superior economic growth and interest rates. Second, the current account balance has moved to sustainable levels. Third, the fiscal deficit has declined sharply. Fourth, US political environment is relatively stable compared to the heavy political calendar in the eurozone this year and next year. Last but not least, the uptrend in the US dollar has just started and the traded-weighted index remains low.