We see EUR/USD as a three-stage rocket and still target 1.25 at year end
With the Fed now in practice 'on hold', the first stage of this has been ignited - but a trade deal and a first ECB hike will be required for true lift-off
Strategic case for the cross to eye 1.30 remains and sell-offs should be bought into
After a rather calm autumn in G4 space, the FX market has had a volatile start to 2019 with notably Fed continuing to withdraw USD support. We have long been hinting that the next big move in EUR/USD will be higher on valuation grounds but stress that a rebound is a three-stage-rocket (Figure 1) - and Fed 'on hold' is only first stage to orbit. To achieve true lift-off it requires that next stages are reached: a US-China trade deal and a first ECB hike.
Will a US-China trade deal be struck? Yes - but it is not imminent. Trade talks have progressed after New Year and helped soothe risk sentiment. For EUR/USD, the effect of this has been felt through both the China and the risk channel. Via China, Europe has arguably been affected negatively by the trade war from faltering private-sector confidence and via CNY appreciation lifting the trade-weighted EUR. We look for a trade deal to come later in H1 and the tariff dispute to fade - both should support EUR and put pressure back on USD to bear the burden of current-account adjustment. Via the risk channel, a trade deal could further help turn the current risk sentiment, which should, in isolation, be a small EUR positive. However, given the USD's now-more-blurred properties as a safe-haven currency, we would not overdo the EUR/USD support potential from a risk recovery.
Will ECB deliver a first hike? Maybe - but the risk of postponement remains and the potential for euro short rates to rise is, after all, limited. We note while that euro-zone capital outflows have showed clear signs of ebbing out in 2018 (Chart 1), but an outright reversal (inflow) still seems somewhat far off given that ECB will be reluctant to move rates much above zero. More broadly, short-end rate spreads have failed to capture EUR/USD shifts in recent years whereas real long-term spreads have done a much better job. Our rate strategists see risks tilted towards a further drop in US real rates near term as inflation expectations should pick up on the back of Fed's rhetoric shift and support to oil prices. This supports EUR/USD at higher levels (Chart 2).
In summary, Fed-induced USD support is now fading, but a trade deal will in our view be key for the next stage of a EUR/USD rebound. Further, while not a trigger for USD strength in itself, carry will support USD still. Also, short EUR/USD positioning should now be a tad lighter, if still stretched. Together with the risk of setbacks on trade talks and a still fragile macro environment, this leaves room for smaller EUR/USD setbacks near term . But, with the break of Oct-18 highs, ranges have moved higher with 1.15 now more likely to be the midpoint going forward. And as Q1 progresses, we expect the second stage to be reached. We still target 1.25 in 12M and clients with USD income/assets should look for opportunities to add to USD hedge ratios. We are long USD carry vs a basket of funding currencies (JPY; CHF; SEK) but remain positioned for EUR/USD upside mid year via options, cf FX Top Trades 2019 .