FX Watch – Euro strength not over yet

by: Georgette Boele

In this publication: USD downtrend and EUR uptrend have started this year and this trend has further to go. The Fed exit experience tells us that euro upside is here to stay. Meanwhile, drivers for the US dollar remain negative for now. Our new end 2017 forecast is 1.20 (from 1.15) but a near-term correction towards 1.15 is likely. Our new year-end 2018 forecast is 1.30 (from 1.20).

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USD downtrend and EUR uptrend have started this year

On 23 February of this year when EUR/USD was at 1.0558 we changed our view and became bearish on the US dollar and bullish on the EUR. Since then EUR/USD has rallied by 13% for several reasons. Investors have become more negative on the US as expectations about a possible positive impact of President’s Trump policies on the economy have faded. Moreover, US inflation numbers have surprised on the downside resulting in a sizeable downward adjustment in expectations about future Fed rate hikes. Furthermore, President Trump’s style of governing has increased (geo) political uncertainty and this has weighed on sentiment towards the US and the US dollar.

On the other hand, drivers for the euro have become more positive. For a start, political risks in the eurozone have faded and this has given a substantial boost to the euro. Moreover, Fed rate hikes are not the only game in town anymore. Other major central banks have signalled that their policies will become less accommodative (ECB) and the Bank of Canada has even already hiked twice. This development has supported the euro and other currencies versus the US dollar. Finally, the eurozone economy has surprised on the upside and this has also supported the euro. All in all, we have experienced a deterioration in US dollar sentiment and a substantial improvement in euro sentiment leading to a strong rally in EUR/USD year-to date. The question is what now? We lay out our view below.

Learnings from Fed tapering experience: more upside euro

In June 2013 Fed Chairman Bernanke signalled that the Fed would start to taper asset purchases from September 2013 onwards. Due to uncertainty in financial markets and doubts about the possible impact on the economy and financial markets, the Fed delayed the announcement until December 2013 and started tapering asset purchases from January 2014 onwards. The QE programme (net asset purchases) eventually came to an end in October 2014. How did the US dollar behave in this period? At first the US dollar moved sideways versus a basket of currencies during the taper tantrum and at the start of the tapering period. However, the dollar started its ascent from the moment on that the balance sheet increases started to slow down (see graph on the left below). In the 19 months that followed the dollar rose by 25% on a trade weighted basis and by 17% versus the euro. In this period the 2y US Treasury yields rose modestly, while 10y US Treasury yields declined.

We think that the euro will follow a similar path. The graph below on the right shows that the rally in the euro has already started at the end of March and coincides with a slowdown in the pace of increase in the ECB’s balance sheet. At this time, the last long-term financing operation was completed and the ECB announced a decrease in net asset purchases from EUR80bn per month to 60bn. Since then the euro has risen by 8% on a traded weighted basis and by 12% versus the US dollar. Going forward, we expect the ECB exit to continue to support the euro. We think the ECB will reduce net asset purchases further in January to EUR 30bn per month, continuing that pace up to September, before the programme ends in Q4 of next year. Against this background, a total rally of 20% to 25% (meaning another 12 to 17% on trade weighted basis) is not unthinkable if we take the Fed experience and its impact on the US dollar into account.

US dollar sentiment will remain negative for now

We expect that US dollar sentiment will remain negative for now. We have reduced the number of Fed rate hikes to two for the coming 14 months and expect a continued pause in the tightening cycle up to March 2018.

Second, the domestic political situation and the geo-political uncertainty will continue to dent sentiment towards the US dollar barring a panic in financial markets because that would result in safe-haven demand for the US dollar.

Third, the long term trend has turned negative for the US dollar this year. This means it is likely that the dollar has started a multi-year decline. In such an environment speculative investors will probably sell the US dollar on rallies.

Upside EUR/USD dampened though

The rally in EUR/USD will probably be dampened somewhat. First, the Fed will start to reduce its balance sheet and continue to hike interest rates at a slow pace (in the coming 14 months) and this should support the US dollar somewhat. Second, the excessive net-long euro positions will probably cause sharp correction waves in case of position liquidation in the near-term.

New forecasts EUR/USD

If we take all the above into account we have increased our year-end forecast to 1.20. In the near-term net-long position liquidation will probably push EUR/USD towards 1.15, but later in the year we expect EUR/USD to move back to 1.20. We have also increased our 2018 year-end target from 1.20 to 1.30. We expect the – albeit slow – ECB exit to support the euro, just as the initial Fed exit did. We expect sentiment towards the US dollar to remain negative and the Fed not to hike more aggressively than financial market now price in. However, the upside in EUR/USD will likely be dampened somewhat as the Fed reduces its balance sheet.