EUR: Can the Bull Run Continue?


There are only two exogenous factors…that can realistically explain the resilience of (Europe’s) recovery: the collapse in oil prices in 2014-15 and our monetary policy.

 

Mario Draghi, ECB President

April 2017

 

 

When we made the decision to revise our EUR forecasts back in June, it was based largely on two factors.  Firstly, the political risks facing the Eurozone had declined following the victory of Emmanuel Macron in France, and secondly, the region’s economy had begun to outperform market expectations.  We reversed our bearish view of the single currency and set a 1.20 target for EURUSD (at the time, EURUSD was trading below 1.12, firmly ensconced in 1.10-1.15 trading range). 

 

We have now reached our 1.20 target, so naturally we must consider whether this EUR rally still has legs.  In other words, do the two factors mentioned above justify a stronger currency than we initially thought, or, might there be other factors coming into play which we need to consider?

 

With respect to our initial rationale for the EUR rally, it is difficult, in our view, to justify much further EUR strength.  The decline in European political risk has now been priced in, and we feel that Europe’s nascent economic recovery has largely resulted from the fact that European economic performance tends to lag that of the US.  In other words, Europe is only making up some of the lost ground that occurred following the last flare-up of the European financial crisis in 2010.  This is reflected in the fact that the Eurozone’s unemployment rate is still effectively double that of the US and the UK.  This is not a case of Europe becoming the world’s new growth engine.

 

That said, there are now two additional factors that must be considered.  First of all, if European monetary policy is turning hawkish, this would potentially justify a stronger EUR.  Whilst there have been recent noises emanating from the ECB that hint at an imminent tightening in monetary policy, we remain sceptical.  As highlighted in Mario Draghi’s quote above, the ECB does not appear to believe that the current economic recovery in Europe is particularly sustainable, at least not without continued loose monetary policy, especially in a less bearish market for oil.  In addition, though aggregated European debt levels are not too dissimilar from those in the US, much of the Eurozone economy is still highly leveraged (e.g. the Italian debt to GDP ratio exceeds 130%, pretty much double that of Germany).  This highlights the dilemma for the ECB – unlike the Fed, it must set monetary policy for a number of very different economies – and this fact makes it much less likely that the ECB will embark on any meaningful monetary tightening for the foreseeable future.

 

Another factor that could drive the EUR higher, is the ‘Trump effect’.  If the market begins to lose confidence in the USD due to the growing risks of a government shut-down, or a geopolitical disaster in North Korea (to name two examples), the EUR would likely become the favoured destination of global capital, which could boost EURUSD well above its fair value (around 1.25).  This is not our expectation, but it is a very real risk to our forecast.  

 

After considering our initial rationale for EUR strength, and assessing these new factors, we are not inclined to increase our EUR forecasts at this time.  In fact, when assessing the current market positioning (see chart), we are increasingly concerned about a potential reversal in the EUR’s recent bullish trend.  Speculative positioning is now reaching extreme levels in the EUR, with hedge funds and other investors piling in to buy EUR against the USD.  Whilst this is no guarantee of a sudden reversal, history shows that on each previous occasion that the market was this long the EUR, a significant move lower was not far behind. 

 

CHART: EUR positioning (blue) and EURUSD (orange)

 

Picture1

 

 

Author: Kevin Lester



 

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