FX Watch – Higher EUR/USD in 2017

by: Georgette Boele

In this publication: US dollar has been under pressure because of weaker US data, lower US nominal and real yields and negative headlines about the Trump administration. Meanwhile, the euro has been supported by lower political risk, strong economic data and ECB tapering expectations. We expect EUR/USD to continue to rise in 2017, because of US political uncertainty, ECB tapering expectations while Fed hikes are mostly priced in. Our new year-end target for EUR/USD is 1.15 (was 1.10). Our end of 2018 forecast remains unchanged at 1.20.

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Introduction

EUR/USD has risen considerably over recent months. EUR/USD has risen by more than 5.5% since the start of this year and broke above our year-end forecast of 1.10. In this FX Watch we assess the reasons behind the move and set out what we expect going forward.

Dollar weakness…

The recent weaker than expected US data, especially CPI numbers and retail sales, have halted the dollar recovery and resulted in a wave of US dollar weakness. This is because these weaker than expected numbers have resulted in a downward adjustment in expectations for Fed rate hikes in 2017 and 2018 (graph above on the right) and more importantly in lower US real yields (a crucial driver for the dollar, graph above on the left). On top of these, negative political headlines about the Trump administration have also weighed substantially on investor sentiment towards the dollar.

…and euro strength

Meanwhile, the sentiment towards the euro has improved considerably. This is because political risks in the eurozone have eased after the results of the Dutch and French elections. Moreover, eurozone economic data have been strong and this has also supported the euro. Last but not least, the ECB is gradually moving into the direction of preparing the market for a tapering of its asset purchase programme in 2018. As we have seen with the Fed, such an environment is positive for the currency and in this case the euro.

More upside in EUR/USD in 2017…

We expect more dollar weakness and euro strength this year for the following reasons. First, a 25bp Fed rate hike in June is fully discounted and a 25bp rate hike in September is for around 50% priced in. So while we expect two further rate hikes this year, it is unlikely that this will provide strong support for the US dollar. Meanwhile, the market will continue to focus on ECB tapering and this should support the euro going forward. Moreover, the negative headlines about the Trump administration will probably remain. This will depress investor sentiment towards the US dollar and trigger more squaring of speculative net-long USD positions. According to the recent data of the commitment of traders report (up to 9 May 2017), speculative net-long positions in the dollar have been cut in half. If investors were to become more negative on the dollar because of the political developments and US data would not surprise substantially to the upside, these positions will likely be cut towards neutral. This could mean another 4% decline in the dollar versus a basket of currencies. Furthermore, the technical picture has turned negative. The US dollar index has broken below the 200-day moving average and EUR/USD above this technical level. This means that speculative investors will look for opportunities to sell the dollar and buy the euro. What will likely dampen the upside in EUR/USD, however, is a refocus on political uncertainty and poor fundamentals in Italy later this year.

…and modest upside in 2018

We remain bearish on the US dollar across the board for 2018. This is because we expect the US growth/inflation mix to deteriorate and US real yields to move lower. Meanwhile, in the course of 2018 investors will probably realise that they have run ahead of themselves about the amount of rate hikes by the ECB in 2018. We expect a 10bp rate hike in Q3 2018, while financial markets are currently anticipating more than a 10bp rate in Q2 2018. We expect that the adjustment in expectations concerning the ECB will dampen the upside in EUR/USD.

Change to our EUR/USD forecasts

If we take all the above into account, we now expect more EUR/USD strength in 2017. Therefore, our new year-end 2017 forecast is 1.15 (was 1.10). For 2018 we leave our year-end forecast unchanged. In the table below are our EUR/USD forecasts per quarter.