FX Outlook 2018 – Euro’s resilience to be tested

by: Georgette Boele

In this publication: 2017 was the year of the euro recovery. In 2018 the euro’s resilience will be tested as drivers become more dollar positive (growth/inflation mix and the Fed) and net-long euro positioning and flows pose downside risk for the euro. In 2019 we expect EUR/USD to strengthen again as dollar positive drivers fade and ECB rate hikes come into focus.

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2017 was the year of the repricing of the ECB exit and the euro recovery…

The surprise of 2017 has been the strength of the euro and the weakness of the US dollar. EUR/USD has risen by 13% year-to-date on expectations that the ECB is moving towards somewhat less accommodative monetary policy. Moreover, stronger than expected growth in the eurozone economy as well as lower perceived political risks have also given a boost to the euro. A strong increase in direct investment and portfolio flows towards the eurozone was the result. On the other side of the Atlantic, investors did not appreciate US President’s Trump unpredictable policy and this has weighed on the US dollar despite the fact that the Fed has continued to tighten monetary policy. In this report we focus on our views for 2018 and 2019.

In 2018 EUR’s resilience will be tested…

In 2017, it took some time before investors were convinced that the euro would rally. We changed our view well (February) before others. Now, investors are convinced that euro strength has further to go. We also belonged to this camp for a while but we have recently changed our opinion on this. We think there is upside in EUR/USD in 2019 rather than 2018. This market conviction of a higher euro is visible in the reluctance of the euro to move lower and the persistence of the excessive net-long euro positions. We think that in 2018 the conviction of the investors that believe in a higher euro and the euro’s resilience will be tested. As long as investors will remain convinced that the euro will rise in 2018, it is unlikely to happen. This is because they are already positioned for it and there is a lack of new buyers. There needs to be some kind of wash-out of net-euro long positions to give the euro the prospect of another leg up.

Speculative positioning is not the only risk for the euro. The sum of direct investment and portfolio flows are also quite substantial. The odds for a further increase in these direct investment and portfolio flows are lower than those for a decrease.

 

There are more reasons why we think that that 2018 is not the year for a higher EUR/USD. First, we expect the Fed to continue to tighten monetary policy in 2018 and this should support the US dollar (this could be as modest as in 2017). We expect two rate hikes of 25bp in 2018 while financial markets only price in one rate hike. Second, we think that US growth has more upside momentum in 2018 than the eurozone. All in all, EUR/USD will probably come under some pressure in 2018 but we expect the EUR/USD trend to remain positive.

…and 2019 the return of euro strength

We expect EUR/USD to strengthen again in 2019 because of a narrowing of the 10y yield spread in favour of Germany. In addition, in 2019, the market will probably focus on the prospect of an ECB hike in the deposit rate and this should support the euro. We expect two hikes in the deposit rates by 10bp each to -0.20%. Moreover, financial markets will probably also increase rate hike expectations for 2020. This is also euro supportive. A continuation of Fed rate increases will probably initially limit the downside in the US dollar in 2019. Once investors start to anticipate the end of the Fed rate hike cycle, the US dollar will probably fall considerably.