EUR/USD, USD/JPY: Themes, Forecasts, & Trade Strategy - BofA Merrill

EUR/USD: Themes: The ECB cannot address what is beyond its control. The March ECB meeting could be the most difficult in recent years, as more easing may not have a sustained market impact. In contrast to the recent past, the ECB is now dealing with global shocks, which are much more difficult to address. The ECB has to think outside the box, but we do not expect it to. Markets could be disappointed, although for different reasons from the ones in December.

Strategy Our strategy remains to trade the Euro tactically. We expect the Euro to weaken further ahead of the ECB meeting, as the bear market rally continues and investors position for more ECB easing. We would also expect Draghi to do his best to avoid another market disappointment. However, we do not expect that more of the same would be enough to offset the global forces that have been driving the Euro this year. We would buy the Euro dip after the ECB meeting—or event before if markets overshoot. In a bear market, we expect global forces to be a stronger driver for the Euro than monetary policies.

Forecasts: EUR/USD at parity by year-end On the back of our economists change to 2 from 3 Fed hikes this year, the addition of a significant risk episode of US QE and our equity strategists revised forecasts, we recently updated our projections and now expect EURUSD to end the year at 1.00 (from 0.95). We expect that divergence of monetary policies will help weaken EUR/USD in the months ahead, as the ECB eases policies further and the Fed does hike again this year, compared with market expectations to be on hold until end-2017. We expect EUR/USD to appreciate again to 1.10 by end-2017, towards our estimate of its long-term equilibrium of 1.16.

Risks: mostly upside. EUR/USD could stay well above parity if the ECB fails to deliver decisive easing this year and the Fed stays on hold. A more sustained Euro weakness needs extremes in our view: either the return of the bull market, with the Fed tightening again and the ECB easing; or a global recession, making the USD a risk-off currency and the Euro a risk-on currency again.

USD/JPY: Themes: USD/JPY in temporary relief, but may test 100 before bottoming out. February was a memorable month for JPY. It rallied significantly and USD/JPY moved more than it did in the whole of 2015. The global equity market declined in January and the BoJ had been facing headwinds against its 2% price stability target. The Bank introduced a negative interest rate at its January meeting, which initially weakened JPY. However, we did not think the measure was enough to weaken JPY until we see fundamental improvement in external conditions, and rather created new risks (see report). With reduced power of policy put, USD/JPY was set to test 110 and it did. In our view, this move toward 110 manifested a clear turn in market sentiment on JPY and its further upside risks in 2016. But USD/JPY’s selloff seemed to end on 11 February on technical exhaustion.

We see three implications. First, JPY’s risk is skewed to the upside and yen buying has better risk/reward in 2016; sell USD/JPY on rallies continues to be a basic tactic. Second, those who need to sell JPY (or buy foreign currencies for Japanese investors) are likely to be rewarded for their patience. But, finally, the yen’s strength is more supported by external factors and once the global market finds bottom and the economy is set to reaccelerate, the yen’s strength will dissipate and the currency may regain structural headwinds and “pent-up” monetary easing effects. Therefore, 2016 could provide a great yen-selling opportunity, but it is likely to require deeper deterioration in risk sentiment and higher JPY level.

Forecasts & Strategy: JPY to rise against major currencies. Beyond the short term, we believe JPY strengthening pressures will persist through 2016 due to macro conditions, and we would sell USD/JPY’s rally. Given the dip into 110, which was the downside risk in our view back in December 2015 (Case for a stronger yen in 2016 18 December 2015), 100 has become a realistic downside risk (around 50% retracement from the 2011-15 rally) while USD/JPY will face sell-on-rally pressure above 115.

Risks: external JPY’s risk is still skewed to the upside, resulting from external uncertainties: a weaker RMB, slower US growth, and political risks. If these risks send the yen higher, the market is likely to test 110 when the BoJ’s ammunition has diminished, and 100 could become a real risk.

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