EUR/USD: 2 Opposing Forces Amid A Shift In USD Relation With Risk
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The USD response to the UK's decision to exit the EU marks a shift in how the greenback trades with risk appetite. For most of last year and until just recently the dollar behaved like a pro-risk currency being positively correlated with changes in global risk appetite. However, in the run-up to the referendum and particularly since last Friday the correlation between the currency and indicators of risk appetite such as the VIX has reversed, with the dollar once again behaving like a safe haven currency.
Will this change last? We see several reasons why it may do so, at least in coming months when markets are likely to be dominated by political and economic uncertainty in the UK and EU. Indeed this kind of uncertainty tends to be normalized fairly quickly. Still, we expect negative consequences for the economy and also political turbulence that will hold market players on alert.
In particular, two opposite factors will impact EUR/USD going forward, as both currencies seem to react similarly to changes in general global risk sentiment.
1- Increased political uncertainty in the euro area and the UK will remain USD supportive.
2- The decreased likelihood that the US central bank will tighten monetary policy this year is USD negative.
Indeed, it seems unlikely the Fed will raise rates at least before December. As we expect the ECB to maintain its current policy for now, the divergence between Fed and ECB monetary policies will be contained, which is hardly USD supportive.On the other hand, currently the market does not expect a Fed hike this year, though present pricing is less extreme than at the beginning of this week when it signalled a small probability of a rate cut by the US central bank
Overall,given uncertainty regarding the political situation in the UK and EU, and the impact of Brexit on the euro zone economy on the one hand, and low expectations that the Fed will tighten monetary policy on the other, we believe EUR/USD will continue to trade between 1.07-1.12 going forward.We would expect the pair to trade towards the lower end of the range if political uncertainty within the euro zone increases and towards the upper end if muted Fed expectations become the dominant factor.
Near-term, however, we believe political forces will dominate so EUR/USD should stay in the lower part of the range. We have revised our EUR/USD forecast to 1.07 at the end of Q4.
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