Strategy
The USD rally paused following the March Fed meeting, as the FOMC voiced concern over the recent downside surprises in US data. We think the time has now come for another leg lower. Notwithstanding worries over the impact of a stronger USD, yesterday’s FOMC minutes keep the door open for a summer rate hike and markets will have to price the Fed more aggressively if US data improve in Q2 as we expect. Relative data surprises have recently moved markedly in favour of a stronger EUR/USD but this should reverse now. We expect this to play out in coming weeks. The US has clearly hit a soft patch but this should be temporary as weather-related distortions fade and exporters adapt to a stronger USD environment; we look for a strong Q2 driven not least by private consumption. In the eurozone, the positive impact of previous falls in oil prices is starting to wane. Notably, German indicators may be close to a peak, hinting that the era of positive eurozone surprises is over for now. As a result, we recommend selling EUR/USD for a target of 1.0050, as we believe parity will see strong support at first sight.
Fundamentals
We have previously sketched how excess liquidity and negative deposit rates fuel a socalled ‘hot potato’ effect, i.e. a search for yield that is EUR negative (see inter alia FX Forecast Update: Draghi + Yellen = EUR/USD parity, 17 March). With excess liquidity set to expand significantly as the ECB continues its QE scheme, we believe there will be more hot potatoes to pass. We expect this to continue to act as a EUR negative as the search for yield includes non-EUR assets and as foreign investors maintain high hedge ratios.
Our rate strategists see upside to the short end of the US yield curve in the months ahead as markets gear up for a first hike from the Fed (we look for this in September). Indeed, upside to rates has historically arrived primarily at the end of Fed easing cycles and ahead of a first hike. With some potential for EUR rates to edge lower still, we see support for a lower EUR/USD from relative rates still. Importantly, whereas many major central banks joined a global currency war in Q1, we do not think that a dip in EUR/USD to around parity will in itself be an obstacle to a Fed hike provided this arrives gradually.
Greece is an omnipresent concern for the eurozone and, in our view, the risk of a Grexit is likely to continue to linger in coming weeks, as funding negotiations continue, i.e. Greece is set to remain a EUR negative for some time. Another factor is oil prices. With global storage full, near-term risks are on the downside; thus oil could drag EUR/USD lower still.
In our view, the two main drivers for EUR/USD downside on a 6M horizon remain monetary policy divergence, as the ECB continues the aggressive expansion of its balance sheet whereas the Fed moves towards policy normalisation. We forecast EUR/USD at 0.99 in 6M but a break below parity is not likely to take place before we have clearer hints that the Fed will go for a Q3 hike as we call for.
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