Cyclical pressure on ECB leaves scope for EUR easing risk premium near term
EUR/USD in range around 1.13 on a 3M (NYSE:MMM) horizon - notably upside risks capped
Hedge USD income/assets with risk reversals and stay long USD/SEK
With one exception (Norges Bank), central banks have in recent weeks given in on 'normalisation' efforts (Table 1) by either going on hold (Fed, BoC), postponing a first hike (RBA, ECB, BoE) or disclosing their locked positions (BoJ, SNB). We now see no more Fed hikes in this cycle ( FOMC review ), and for USD this means that carry momentum is ebbing out amid stretched long positioning and overvaluation. A USD downtrend? It is too early as talk of rate cuts is premature with the US economy to stay in decent shape this year. For EUR, a key question is if ECB will shift its rhetoric to whether - rather than when - a first hike is warranted. The bar for ECB to 'do more' is clearly lower after the March meeting, but it remains high due to a constrained toolbox and a new president in the autumn.
What then about EUR/USD? The cross has decoupled from relative rates lately: rate spreads have moved in favour of a higher EUR/USD - both in nominal and real terms (Chart 1) and across tenors. Our Short-Term Financial Model estimate currently stands at 1.15 (Chart 2). Together with a smaller risk of a no-deal Brexit, this helps to explain why the cross has failed to move lower despite Eurozone weakness lately. Will this support last? We think not. Global nominal yields have grinded lower since early autumn, but so have inflation expectations, suggesting market confidence in central banks has been in decline. In the US, break-even inflation rates started to recover around New Year when Fed shifted its stance, but Eurozone ones still look fragile. Thus, euro real rates remain on the rise (Chart 3) and elevated spreads to the US do not seem warranted by relative cycles. We expect global growth concerns continue to linger near term - indeed our quantitative business-cycle model Macroscope increasingly calls for stamina in this respect - which suggests ECB will have to put its money where its mouth is and bring lower real yields. Will it deliver? History says not (enough): that said, we do see potential for a wider 'ECB easing risk premium' to weigh on EUR/USD ( FX Strategy ), but to send EUR/USD below 1.10 will require a fundamental shift in ECB's stance on rates (e.g. more negative) and we doubt that will be delivered. However, we are not in for a firm EUR uptrend either just yet: for this, we need much firmer signs of a self-sustainable Eurozone recovery.
On a 3M horizon, we see EUR/USD trapped in a range around 1.13 but with risks tilted to the downside as ECB will be forced to keep a soft stance at a time where Fed looks more side-lined. Relative cyclical hints will be key near term - but a trade deal could be a knee-jerk USD positive. Beyond the 6M horizon, a drift higher will materialise as the skies clear a bit for the Eurozone, but we still merely target 1.17 in 12M. For now, ECB has effectively put a lid on the cross and with still heavy carry, we continue to advocate risk reversals when hedging USD income/assets. From FX Top Trades 2019 we are long USD (versus SEK, JPY, CHF) for the carry, but due to the outlook for a fragile risk environment for some time still we close the JPY and CHF legs (Table 2), effectively leaving us long USD/SEK spot.
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