The USD has appreciated against the EUR since early September and is getting close to our year-end forecast of USD1.15 per EUR. The USD’s recovery is supported by a combination of better US growth and renewed hope of tax reforms, which could add pressure on Fed to hike rates. However, we continue to consider the current USD rebound a countertrend consolidation, which will ultimately lead to a resumption of trend mean-reversion of the USD lower towards longer-term fair value.
The strong USD uptrend since 2011 has probably peaked, as monetary policy divergence gives way to synchronized global growth and G10 policy convergence (towards the Fed’s tighter stance). UK is the latest to join the G10 tightening cycle. History shows only two prior multi-year rallies in the USD since Bretton Woods: 1980-85 and 1995-2001. The former a period of easy fiscal and tight money, with a very strong US economy. The latter the tech and US (over) investment boom.
Strong USD uptrend since 2011 has likely peaked
The EUR is set to lead in driving the USD’s gradual transition to a multi-year decline. 'Goldilocks' macro backdrop of anchored inflation and strong growth in the US as well as lack of any extremes in USD overvaluation of any length means that the USD decline can be gradual. With the exception of European currencies, the USD might be expected to bump around in ranges against the rest of G10 currencies rather than go anywhere very much. We thus continue to see the JPY remaining in a likely 107-116 range and the AUD at 0.74-0.81 against the greenback going into 2018. This is before giving way to more broad-based USD downtrend in 2-3 years’ time. It will make increasing sense to sell USD rallies in contrast to the past six years of buying dips.
Rising US recession risk causing Fed to go into full reversal mode of rate cuts instead of hikes will be needed to bring about broad USD weakness. But risk of this condition being met over the next year seems low for now. Expensive US equity valuations could eventually make the aging US economic expansion vulnerable to any setback but is not, by itself, sufficient to spark an imminent recession.
We are targeting an eventual EURUSD move to 1.24 in a year’s time and see dips near to 1.15 as a medium-term buying opportunity. The next leg higher in EUR may have to await for signals that the European Central Bank (ECB) is willing to normalise policy faster than currently priced and for Italian election concerns to blow over. This suggests that the bulk of EUR appreciation may come only after first quarter of 2018.
The October ECB meeting delivered broadly the consensus on QE tapering and forward guidance, with a dovish tone, but without offering more specifics. We think that the ECB’s excessive gradualism is inconsistent with the underlying growth trends. Ongoing strength in Eurozone cyclical indicators suggests continuation of, rather than retrenchment from, repricing monetary normalisation. EUR’s long-term uptrend should be well supported by the currency’s still cheap valuation and the steady improvement in the underlying pace of growth trends.
Meanwhile, European political risk has returned to prominence, but has not shifted sufficiently to materially rethink policy normalisation, which will remain a dominant driver for European currencies. The next Italian election is approaching fast (due by 20 May 2018 at the latest) and could make even bigger waves in markets than Spain’s current travails given that anti-EU and anti-establishment sentiments are among the strongest in the EU. Italy will probably be able to continue muddling through in our view.Disclaimer applicable to recommendation
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