Euro to Dollar Could Decline in Week Ahead if Risk Appetite Persists
A look at the the week ahead for the EUR/USD pair.
The euro could be vulnerable to external threats next week, particularly if risk sentiment continues pulsing higher, as several analysts from large banks including HSBC and Bank of America (BofA) are forecasting.
As a popular source of funding both for the carry trade and to purchase emerging market assets, the euro is susceptible to being targeted and sold in risk-on environments.
The ECB’s move to lower even further base lending rates will make the euro even more attractive as a source of funding.
The carry trade involves investors buying a higher yielding currency such as the New Zealand dollar or the Brazilian Real using a lower yielding funding currency such as the euro or the yen.
The trader then benefits from the interest rate differential between the two currency’s countries.
Boris Schlossberg of BK Asset Management, puts it succinctly:
“If risk assets continue to rally the unwind in the euro could persist and the pair could tumble all the way to 1.1000 level as the volatility seesaw continues. Ultimately however the pair remains under fundamental pressure and if at next week's FOMC meeting the Fed hints that it may resume its tightening cycle the downward move in EUR/USD will resume in earnest.”
According to Bank of America ‘risk-on’ is set to extend, so the euro may go lower:
“Central banks spur risk-on: in run-up to ECB/BoJ/Fed flows risk-on, particularly in credit...bond inflows ($6.1bn), equity inflows ($4.5bn), gold inflows ($1.0bn) and Money-Market outflows ($3.6bn).”
This risk-on is coinciding and fuelling a renewal of interest in emerging market (EM) assets:
“Largest inflows to EM debt in 12 months,1st inflows to EM equity funds in 5 months, largest 3-week inflow to High Yield bond funds in 3 years, 9th consecutive week of inflow to gold funds (longest streak since 2012).”
Risk On Not For Too Long
Nevertheless, BofA add the proviso that ‘risk on’ will probably just be a temporary factor influencing the markets.
“Risk assets about to top: ultimately markets about "rates" and "earnings", little else; central banks have played "rates card" as aggressively as they can; ECB done, BoJ has nothing in the tank, and any US macro strength will elicit Fed rate hike expectations(the Fed wants to tighten); EPS momentum simply not strong enough near-term to overwhelm Q2 risks of Brexit, BoJ failure, US politics, China debt deflation.”
Yet they still see EM as a buy.
Risk of ECB Changing Tone
The euro’s rollercoaster ride during the ECB meeting saw it fall initially as a result of the greater-than-expected policy response, but then volte-face and rise after Mario Draghi emphasized the ECb would not be making any further cuts to rates – as if he were saying that’s its we’re done.
Some analysts think markets over-reacted to his statement and that he hastily added that he was talking about current conditions and that things might change, forcing further cuts.
If the reaction was potentially over exaggerated there is a risk that the euro could weaken if further ECB commentary - either from Draghi or his minions once again raises the possibility that policy is actually open-ended rather than closed.
FOMC Ahead
The dollar will be put centre-stage at the Fed’s March rate meeting on Wednesday, which is also one of the four FOMC’s per year to include a press conference with Jane Yellen afterwards.
Most analysts agree that the Fed is highly unlikely to raise interest rates as had been expected previously, however, there remains an outside chance the Fed may want to surprise markets by slipping in a hike when no-one is expecting it as, the RBNZ did in New Zealand last week.
According to Commerzbank, US Fundamentals are strong and markedly distinct from the euro-area, which means the Fed are likely to stick to their normalization programme:
“The Fed, on the other hand, at its meeting next week is unlikely to hike rates further – but only for now. In the US, in contrast to the euro zone, full employment has been reached, with inflation pressure gradually increasing, particularly in services. Hence the Fed seems set to hike rates more strongly (i.e. twice) than expected by the markets, which will lend support to the US dollar and cause yields to rise. “
“The economic recovery continues and inflation pressure is slowly rising. We indicate that higher inflation pressure is to be expected in services in particular. The Fed is therefore likely to raise interest rates more (twice) than the markets currently expect. This will support the dollar and cause yields to rise.”
The first signs of wage inflation are making themselves felt in the services sector where business costs are more sensitive to wages, and less to the global meltdown in commodities. For manufacturing it’s the price of raw materials and imported goods which are normally the highest cost and these continue to remain low due to the global economic slow-down.
“The core inflation rate for services has already risen from 2.4% to 3.0% since May 2015 and more inflation pressure is in the pipeline given that the unemployment rate has kept falling (and is likely to fall further). The prices for services should therefore rise at a sharper rate in future. As services account for 75% of the core index, rising inflation in this area carries more weight than the barely existent inflation pressure in goods prices, which is unlikely to change very much initially given the firm dollar and spare global capacity. The core inflation rate for consumer prices already rose to 2.2% in January; the consumption expenditure deflator (PCE), which is preferred by the Fed, showed a rate of 1.7%. Consequently, the Fed’s 2% target is slowly coming within reach.”
EUR/USD Chart View
Broadly speaking the medium term outlook remains that the pair continues trading within a range between 1.0500 and 1.1500.
The exchange rate moved down to the lower 1.08s following the ECB meeting statement and then rose to 1.1217 after Mario Draghi’s statement that this would be the last time the ECB would cut interest rates.
The R1 Monthly Pivot at 1.1226 provided resistance to the surge higher in the euro, and the rate rebounded off it.
The monthly pivot is a line constructed from the previous month’s High, Close, Open and Low prices, which traders use to buy and sell at, and which it is likely to provide an obstacle to further gains.
The MACD indicator in the bottom pane has just turned positive, indicating more probable bullish potential.
A break above the February 11 highs at 1.1376 would be necessary to provide confirmation of more upside, to a target at 1.1495 October 2015 highs.
Confirmation of more down-side on the other hand, would come from a break below the 1.0800 level, to an initial target at 1.0700, and then the S1 Monthly Pivot level at 1.0663.
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