Euro Exchange Rate Strength Unsustainable: Scotiabank

Euro Exchange Rate Strength Unsustainable: Scotiabank

21 April 2016, 13:34
Vasilii Apostolidi
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This April has seen the euro trade towards the upper end of its 14-month range against the dollar following an impressive 4% rally through March.

  • "We now expect EURUSD to bottom out at 1.02 late this year"
  • Eurozone recovery is on track, but will remain fragile and lackluster
  • "We have opted to recalibrate our expectations in view of our changed assessment of Fed’s monetary policy normalisation course"

Much of the strength in the euro exchange rate complex has been driven by a material reassessment of the outlook for relative central bank policy and gains amplified by adjustments in sentiment and positioning.

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The broader US dollar (USD) meanwhile continues to trade with a weak undercurrent despite decent underlying economic strength, reflected primarily via positive labour market developments, benign inflationary pressures and resilient domestic consumption.

Overall, 2016 so far has been unkind to USD bulls, with the Fed choosing to stand pat on interest rate policy in March, and Fed Chair Yellen emphasising downside risks to the US economy originating from external factors.

Despite the pro-EUR dynamics witnessed over recent weeks analysts at Canada’s third largest bank by assets, Bank of Nova Scotia, have told clients they retain a bearish stance on the euro.

The position is premised on a fundamentally-driven forecast for EUR; however, analysts have moderated the extent of the anticipated decline.

“The strength in the EUR is unsustainable. Support for the USD from the asymmetric growth and diverging monetary policy dynamics between the US and Europe has yet to materialise but we find it hard to get too negative on the dollar,” says Pablo F.G. Bréard at Scotiabank.

At the same time, Bréard fails to find enthusiasm on the EUR.

“We cannot exclude the potential for EURUSD to gain towards 1.15 in the short run, but sluggish Eurozone growth and extremely low inflation (and inflation expectations) will weigh on the EUR later on in the year,” says Bréard.

Furthermore, a more aggressive European Central Bank QE programme (increasing asset purchases to EUR80bn/month from EUR60bn) with enhanced liquidity support for non-financial corporate debt issuers should encourage EURUSD bears.

In addition, Scotiabank say relative central bank balance sheet considerations and the risk of euro zone portfolio outflows due to negative interest rates and Brexit-linked uncertainties, remain important EUR-negative factors.

Analysts believe a UK exit from the European Union may also have negative implications for the EUR saying a UK withdrawalmay weaken EU structures and fuel concerns about a Eurozone breakup.

On the economic front, while hard data, such as industrial production and retail sales, also started the year off very strong, though there is a risk of downward pay-back in the months ahead given global growth uncertainty and the potential adverse impact on confidence from the devastating terrorist attacks in Brussels on March 22nd.

“This suggests to us that the Eurozone recovery is on track, but will remain fragile and lackluster, which combined with subdued oil prices will keep inflationary pressures in check,” says Erika Cain, economist at Scotiabank.

US Dollar: Strong Fundamental Underpinnings

Scotiabank meanwhile remain constructive on the USD over the balance of the year after the US economy appeared to have lost some momentum around the turn of the year, with underlying GDP growth trending around 2% y/y.

Dollar weakness came as the Federal Reserve downgraded its outlook for the amount of interest rate rises that it anticipates undertaking in 2016, with the median forecast for the Federal Funds rate at the end of 2016 dropping to 0.9% from 1.4% at its January meeting.

This implyies that the FOMC now anticipates only changing the funds rate twice this year, down from the four expected at the end of 2015.

Nevertheless, sentiment on this front is forecast to improve.

“Consumer spending and housing activity remain well supported by pent-up demand, a robust job market, rising income gains, solid household balance sheets, cheap gasoline prices, and low borrowing costs,” says Scotiabank economist Neil Tisdall.

Further pro-USD pointers include the strongest pace of job growth in a decade and a half has pushed the unemployment rate below 5% for the first time since 2008, and underpinned strengthening labour force participation rates and wage gains.

Consumer confidence and buying intentions remain upbeat. Motor vehicle sales are running near record levels, and retailers are reporting healthy, albeit moderate, sales growth.

The US economy also is getting a lift from a pickup in federal and municipal government spending.

Inflation pressures are edging up notwithstanding the deflationary impulse from a strong US dollar, led by rising shelter and medical care costs.

“However, we have opted to recalibrate our expectations in view of our changed assessment of Fed’s monetary policy normalisation course (two 25bps rate hikes this year, from four). We now expect EURUSD to bottom out at 1.02 late this year and expect USDJPY to end 2016 at 118,” says Bréard.

Forecasts for the Euro to Dollar Exchange Rate

How do these divergent views on the outlook feed into the expected performance in the euro/dollar exchange rate for the remainder of 2016 and into 2017?

Analysts are forecasting the euro to reach 1.08 by mid-year, an upward revision in light of the recent strength in the euro exchange rate complex.

The rate is however expected to fall towards 1.05 by September, ahead of bottoming out at 1.02 by the year end. By the second quarter of 2017 the EUR/USD exchange rate is forecast to have risen to 1.05.

The end of the year sees a tentative 1.12 pencilled in. 

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