Since the Fed announced its first rate hike in mid-December last year the dollar has weakened by around 4.5% against the euro from approximately 1.08 to 1.13.
It is not that unusual for the greenback to depreciate following the initial rate increase in a new hiking cycle. In fact the dollar has lost ground during the first 100 days after such an increase in every hiking cycle since 1994 (see graph below, in which the zero line represents the time of the first Fed rate hike). Perhaps therefore we should not be surprised by the EUR/USD reaction since last December.
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Back in November we observed this historical pattern and viewed a weaker dollar following the first rate hike as a risk to our main scenario, which saw a continued strong dollar based on further policy divergence between the Fed and other central banks. Basically we thought there were two reasons why it seemed less likely history would repeat itself this time.
Firstly, in previous Fed hiking cycles the negative dollar reaction following the first rate hike might simply occur because the Fed had proved less hawkish than expected after the initial rate increase, in turn disappointing markets that anticipated a series of such hikes. This time around expectations for future rate rises were already muted and most likely would need to be revised higher.
Secondly, in previous hiking cycles other central banks like the ECB were quicker to follow the Fed in lifting policy rates. Instead, last December expectations for other central banks were that they would move inthe opposite direction and ease policy further. Therefore, even with muted expectations for Fed policy the case for divergent monetary policy would still remain intact.
However, with the benefit of hindsight it appears the situation was not so different this time after all given the EUR/USD reaction since the policy rate was first raised in December last year.
SO WHAT TO MAKE OF IT? In contrast to 1999 and 2004 when there were strong trends in EUR/USD based on long term structural factors the situation is different on this occasion. A key factor behind the appreciation of the dollar since 2014 has been market expectations that the Fed will cease to ease policy and eventually begin to tighten it, rather than being driven by various long-term structural factors. In this sense we would argue that the underlying situation in EUR/USD is much more similar to the situation when the Fed hiked for the first time in 1994.
Therefore, without any strong underlying trend in EUR/USD, with positioning showing that speculative accounts remain net short in EUR/USD, although it has been sharply reduced, and with the long-term fair value for the currency pair somewhere between 1.15 and 1.20, it is at least possible that the correction higher in EUR/USD, which began earlier this year, may continue for a while longer in line with its development in 1994. To fully reproduce the situation then, this suggests approximately a further 5% upside in EUR/USD before it stabilizes, i.e. at almost 1.20.
On the one hand, it may appear as if history rarely repeats itself completely. Certainly, it is difficult currently to identify a US-related trigger that might plausibly turn EUR/USD around in the near-term. On the other hand, there are several reasons why we might expect the dollar to recover in the medium term. Although the Fed may move more slowly than we have previously expected, there is still a case for a divergence in monetary policy between the Fed and ECB towards H2 this year, which markets do not currently discount. Moreover, an adverse outcome in the UK Brexit referendum in June is likely to hurt the euro but probably benefit the dollar. Finally,we consider the euro to be one of only a few global funding currencies today, which means that it is likely to suffer against the dollar in an environment in which global growth recovers and risk appetite improves.
Nevertheless, to reflect the near-term risks based on history we raise our 1m and Q2 EUR/USD forecasts to 1.15 and 1.16, respectively. However, we still believe the dollar will recover in H2 this year and EUR/ USD should trade back below 1.10 by year-end.