In last week's FX Forecast Update: February - sterling to shine in 2014, we kept our EUR/USD profile unchanged, thus still seeing the cross at 1.26 in 12M but stressed that risks are increasingly on the upside. Notably, there is now a heightened risk that both the ECB and the Fed may temporarily remove support to our baseline call for a slide in EUR/USD this year. We assess the likely FX implications of this so-called "risk scenario" below: EUR, AUD and GBP are prime candidates for upside against USD if this scenario (not our baseline) materialises.
Since the summer of 2013, we have held the view that relative monetary policy would induce a gradual downward move in EUR/USD. While the usual key driver, namely relative interest rates, has supported this call recently, the cross has failed to adhere to this and remained stubbornly in the high 1.30s since the autumn.
One factor behind the support for EUR/USD has been the decent peripheral bond-market performance at the start of the year followed by emerging market turmoil: the former supported the euro whereas the latter seemingly spurred expectations that the Fed would halt normalisation of policy (US dollar negative) should emerging market jitters endanger the global recovery. Now we are in a situation where emerging market worries are subsiding, although challenges remain, but, in the meantime, the US recovery looks weaker than we previously projected.
On the whole, we still expect to see EUR/USD eventually come under pressure from relative rates as our rate strategists see little potential for lower rates in the short end of the US money-market curve and also expect euro-zone rates to remain anchored by the ECB (see Yield Forecast Update: Still waiting for more ECB easing, 14 February). But, while our baseline scenario remains an ECB cut in both the refi and deposit rate in March (or April) and for the Fed to go on with tapering despite bumps on the US road to recovery, we acknowledge that risks are now increasingly on the upside for EUR/USD and these stem from both the Fed and the ECB outlook. We discuss these risks and the likely FX implications of what we denote the “risk scenario” further below.
Risk1: soft US recovery points to risks of a Fed tapering pause
In Strategy: Weaker US growth picture leaves risk assets vulnerable, our economists emphasise that it is not just bad weather at the start of the year that is behind the latest softness in US data. Softness is more broad-based as the support to US growth in H2 from inventory build-ups, lower oil prices, a reduced savings ratio and housing strength was temporary and now starting to wane. This is weighing on the growth outlook for H1.
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