Has the USD peaked?

‘Next week the (ECB’s) Governing Council will have to assess whether progress so far has been sufficient to warrant a gradual unwinding of our net purchases.”


Peter Praet, Chief Economist, ECB, June 6 2018


EURUSD has had a hectic three months, dropping almost 10 cents from its March high, to a low just above 1.15 in May in the wake of the Italian political crisis.  It has since bounced back up to 1.18 as the Italian crisis has stabilized (as discussed last week) and the ECB has reiterated that it still intends to at least discuss the rolling back of their quantitative easing programme. With the Bloomberg consensus forecast still pointing to a stronger euro (median forecast is 1.22 by year end) and the ECB talking about shifting away from an uber-dovish monetary policy, is the worst now over for the single currency? 


In our view, there are two primary reasons to make a bullish case for the euro.  Firstly, there is the possible shift in the view of the ECB, as mentioned above.  For this to really create a tailwind for the euro, however, we would have to see some re-pricing of European interest rates expectations.  In other words, tapering QE by itself will not be enough – the market will have to start expecting that the ECB will begin raising rates to really justify buying the euro – otherwise the theme of monetary policy divergence will continue to support the USD.  Last week we saw the markets reprice expectations of a hike from October 2019 back to July 2019 – which is clearly a move in the right direction for the single currency but probably not enough to justify further euro strength when four rate hikes are expected in the US this year alone.  


The second reason is valuation – according to a raw purchasing power parity (PPP) measure, the recent drop in EURUSD means that the euro is becoming materially undervalued (by up to 10% or more, depending on the methodology used).  This opens the possibility for a rally back towards 1.30 over the longer term.  However, there are two important caveats here: Firstly, PPP is a notoriously unreliable indicator over shorter (<1 year) time horizons, and secondly, spot rates can easily undershoot ‘fair value’ by 15 – 20% before a correction happens – implying that another 5 – 10% of downside  risk exists before the valuation effect kicks in. There are also a number of compelling arguments that EURUSD has further to fall:


  1. Political risk – in our view, the euro should bear a political risk discount due to credible doubts concerning the long-term sustainability of the single currency.


  1. Carry – according to most carry models, which link FX rates to interest rate differentials, the USD is still under-valued based on interest rate differentials alone (as the USD weakened significantly last year, despite rising US interest rates). Using this metric, EURUSD should be trading below 1.10, rather than above 1.20.


  1. European economic performance – following a strong performance in 2017, the euro zone economy is underperforming this year. Notably, euro zone exports contracted in Q1, which is a serious risk to an export-driven economy.



In our view, therefore, the downside risks to EURUSD still warrant a bearish view, although it is fair to say that a lot of the move lower that we were expecting has now occurred. 


Author:  Kevin Lester



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