We revise our EUR/USD forecast lower and expect the cross to move into a 1.05-1.10 range for the rest of the year. No respite in the US-China trade conflict, insufficient dovishness from the Fed and the dollar’s mighty carry all suggest EUR/USD trades lower. The big change compared to previous years is that EUR/USD is no longer meaningfully undervalued!
The reasons we are lowering the forecast are as follows:
- Further deterioration in the US-China trade war
- Already very aggressive market expectations of Fed easing, making it hard for the Fed to ‘surprise’, while the dollar is still enjoying a very appealing USD carry
- No longer stretched valuation
- Close to neutral speculative positioning
All of this suggests that EUR/USD should grind lower over the course of this year. Below we look at these four reasons behind the expected EUR/USD weakness in detail.
Figure 1: Eurozone is one of the most open economies in the G10 FX space
Source: ING, Macrobond
The trade war effect to be more negative for EUR
Despite recent positive comments from US and China officials, we look for further deterioration in the trade war this year. This is because we expect China to stand firm in its rejection of some US demands (i.e. the issue of intellectual property rights and US interference in China’s strategic goals), meaning more US tariffs are set to kick in (see Monthly Economic Update). Stiffer headwinds to global trade will keep the eurozone economic glass half-empty (being one of the most open economies in the G10 FX space compared to the relatively closed US economy – Figure 1). A difficult environment for risk assets – especially if corporate earnings guidance is re-aligned with worsening economic prospects – should further underscore the safe-haven attractiveness of the (high yielding) dollar.
There is also a non-negligible risk of the US imposing, or at least threatening to impose auto tariffs on eurozone exports. This should re-appear on the market’s radar in mid-November. The overhang of such tariffs should also keep the EUR/USD upside relatively muted and prevent investors from entering into strategically bullish EUR positions.
Figure 2: Market already pricing in aggressive easing from the Fed
Very high bar for the Fed to (over) deliver…
While the Fed looks set to cut more this year and next (our economists look for two cuts this year and one cut in 1Q20), plenty is already priced in. As Figure 2 shows, the market pricing is rather aggressive (four-and-half interest rate cuts priced in by end-2020). This is turn raises the bar for a dovish surprise from the Fed. Indeed, the Fed would have to signal / embark on an aggressive easing cycle for the US dollar to weaken. This would typically come closer to a recession and be associated with dramatic yield curve steepening. This seems unlikely at this point as (a) the US consumer remains resilient (as per solid July US retail sales); (b) should we see a more meaningful slowdown in global growth, the Fed is unlikely to be cutting rates in isolation and other central banks are likely to ease as well, partly offsetting the Fed easing cycle. This is what we have observed over recent months and that’s why the dollar has remained resilient.
Indeed, as Figure 3 demonstrates, despite the recent decline in the US interest rate differential versus G10 FX, this rate spread is still high and attractive enough, meaning that its decline has not affected USD negatively so far. In fact, we estimate that it would take another 50-75bp of Fed rate cuts for the interest differential to fall sufficiently (the red dot in Figure 3) to get back into the territory where it should start to matter more for the dollar and act as a negative driver. As the same figure shows, historically, the interest rate differential needs to be comfortably within the 1 standard deviation territory for its correlation with the dollar to rise and thus be negative for the currency (when US rates decline). At this point, we are not there just yet.
Figure 3: USD rate differential still high
… with the dollar still being the carry king
USD still enjoys high carry (2.6% vs EUR over 12 months), making short USD positioning unattractive. As Figure 4 shows, no currency in the G10 FX space offers a higher yield than the dollar, with EUR being on the wrong side of the chart. In real rate terms, EUR has the second-lowest (and most negative) real rate in the G10 FX space (only after the Swedish krona), as per Figure 5. Another way to look at this high dollar carry is what it means for corporate hedging costs. For European corporates, the 2.7% three-month hedging costs make the dollar expensive to sell/cheap to buy. And for US corporates, the EUR is cheap to sell/expensive to buy. As above, we believe short-term US rates are going to have to come down quite a lot – maybe as much as 75bp to make a serious dent in trans-Atlantic hedging decisions.
Figure 4: EUR’s carry is not appealing
Valuation: EUR/USD is no longer undervalued
Importantly, we note that on a medium-term basis, EUR/USD is not undervalued (Figure 6). This is because over the course of the last year, our estimate of the EUR/USD BEER fair value declined due to an improvement in the US terms of trade (one of the key explanatory variables in the model). With EUR/USD no longer stretched, this means that the pair has scope to decline even further before hitting the valuation limits (which should then provide a soft floor under the cross). The latter was the case in 2014-2016 (Figure 6) when the ultra-cheap EUR/USD valuation (given that the EUR/USD fair value was higher back then than it is now) really did limit EUR/USD downside. In short, we believe valuation considerations provide no support to EUR/USD at current levels.
Figure 5: EUR suffers from the second lowest real rate in G10 FX space
Source: ING, Bloomberg
Speculative EUR shorts not excessive
The short EUR/USD speculative positioning is not stretched. It is currently 8% of open interest versus an average 30% between mid-2014 and end-2016 (Figure 7) when EUR/USD was trading below the 1.10 level. This means that more EUR shorts can still be built and positioning does not act as a limiting factor behind the EUR/USD fall.
Figure 6: EUR/USD is fairly valued on medium term basis
Figure 7: EUR/USD speculative shorts not stretched
Source: ING, CFTC
Read the original analysis: EUR/USD: Lower for longer as dollar is king