Euro / Dollar Could be @ 1.30 Next Year Suggests Eye-Opening Call from Societe Generale
The success of pro-European Emmanuelle Macron in both the presidential and now general elections has driven the single currency higher by reducing the risk of the Eurozone breaking up.
Political risk had been an important factor restraining the European Central Bank (ECB) from normalizing monetary policy, particularly when Marine Le Pen was threatening to win the presidency.
With Macron in place and the European project back on track, however, there is a greater chance the ECB will begin to unwind its bond purchasing programme and raise interest rates.
Higher interest rates are positive for a currency as they draw foreign capital, so by the same logic, the process of normalising monetary policy is likely to fuel a strong recovery in the Euro.
But it is not just that the Euro will rise when the process begins - but that it could rise suddenly and rapidly, like a “Jack in the Box when the lid starts opening,” says Société Générale’s FX Strategist Kit Juckes.
“Interest rate volatility fuelled by central banks exiting accommodation will be channelled towards FX. In the process, the EUR/USD skew could flip in favour of EUR calls for the first time since 2009,” notes the strategist in a note to clients.
'Calls' are options which appreciate when a currency rises and so indicate a bullish outlook for EUR/USD – with a target an end of year target at 1.20 according to the strategist.
1.20 may even be a conservative estimate according to Juckes' colleague Oliver Corbier, who sees the possibility of move up to 1.30 based on, "technicals, undervaluation, EA strong capital surplus and the ECB withdrawing from QE," which are, "strong forces that may propel the euro much higher than our 2018 forecasts."
Yet the process of appreciation may not be in a straight line either, but rather a route filled with twists and turns, as the ECB is likely to fight the Euro’s rise.
Fear of upsetting the fragile recovery in the Eurozone economy, especially in the periphery, could make the ECB reluctant to normalize, as this would hit exports by pushing up the value of the Euro.
“Given the fragility of the European economic recovery, and of the financial system in much of Europe, the ECB will likely be reluctant to declare the all -clear too soon and do anything that encourages sharply higher yields, a stronger euro, and threaten the improved growth outlook,” said Juckes.
The ECB will be fighting a losing battle, however, as the path of normalisation and a higher Euro appears inevitable.
“Chances are it can’t prevent the euro from heading higher against the dollar –not in a straight line, and not without some resistance from Frankfurt, but higher all the same,” said Juckes.
By using quantitative easing, or bond buying as it is also known, to keep interest rates artificially low, the ECB has prevented the natural tendency of a weak currency to rise as it attracts more inflows from investors scouting for deals and increased exports.
This explains the fact the Euro remains undervalued on a Purchasing Power Parity (PPP) basis despite the region’s high current account surplus.
PPP evaluates a currency against another currency based on the cost of an identical basket of goods in two countries.
If the hypothetical exchange rate implied by the price difference of the basket of goods is below the real exchange rate then the currency is overvalued and likely to fall – if it above the currency is undervalued and likely to rise.
Currently a basket of goods in the Eurozone compared to the US cost more than the exchange rate would imply, suggesting the Euro is undervalued to the USD.
According to Juckes the undervaluation is a side effect of central bank monetary policy which has kept interest rates low and therefore capital inflows down.
When these policies are unwound, however, they could lead to a sudden ‘back-lash’ appreciation in the Euro.
“The eurozone, along with Japan, has both a sizeable current account surplus and a currency that is undervalued relative to the dollar on the basis of PPPs. That’s a neat trick in the low interest rate world of G10 currencies. The other big surplus countries, Sweden, Denmark, Switzerland and Norway, all have overvalued currencies on that basis. Japan and the eurozone have managed this by combining large -scale central bank asset purchases with negative policy rates.”
Now that Eurozone political risk has eased, capital inflows are pouring into the Eurozone, already supporting the Euro.
Preliminary elections show president Macron’s En Marche party is expected to win the general election on Sunday with a big majority.
This is already increasing demand for French bonds from investors and has led to a rise in debt issuance from French companies, which is likely to attract further inflows of capital.
“A flurry of European corporate bond issues has demonstrated the strong demand since President Macron was elected in France. If that translates into capital inflows, the balance of payments will become very euro - supportive, and the risk that this triggers a sharp euro rally, even if it’s only temporary, remains significant,” said Juckes.
Comparison with 10-year Yield Differentials
According to SocGen the differential between 10-year bonds in Europe and the US provide the most reliable valuation model for the EUR/USD over the last 12 years.
So what does the model say about the second half of 2017 – is it backing up Juckes’s theory that the Euro will jump higher like a Jack in the Box?
Actually not, the model is forecast to only flatline in the second half of 2017, not rise as would be expected given the macroeconomic analysis.
Nevertheless, despite this Juckes does not see the two as necessarily incompatible.
He thinks the EUR/USD will outperform the model, since it often shows a propensity to run higher than the model for extended periods of time during rallying phases.
As such the forecast for the differential to go sideways could still be compatible with a bullish expectations for EUR/USD – especially a short-term one.
“Since our forecast for the 10y Treasury/Bund spread is for it to flat-line around 180-200bp for the next year, the lines don’t really go anywhere, but instead suggest a range for EUR/USD of 1.05 -1.20. We’re in the middle of that range at the moment, though the euro currently appears high relative to yield differentials, as speculators are becoming bullish and long. However, the pattern of trading close to the top of the implied EUR/USD band in bullish phases leads us to think EUR/USD can get to, but struggle to stay above, 1.20 in the months ahead,” said the SocGen analyst.
The US Dollar has Shaky Fundamentals
The other main component for Jucke’s forecast for EUR/USD to reach 1.20 by year end, is that the Dollar side of the pair will depreciate.
“The third big US dollar rally of the post -Bretton Woods era has stalled. At current levels, it’s significantly overvalued, and a shift in the relative momentum of economic growth and monetary policy from the US to Europe suggests that new highs are unlikely,” notes Juckes.
What could make the mighty Dollar stall, especially as US growth is set to rise. Unemployment is at record lows and the Federal Reserve looks like it is itching to raise interest rates – and what’s more will be the only central bank in the developed world to be considering more hikes?
The answer to why the Dollar will stall is that US growth will moderate lower.
“After growing at a modest rate of 2.1% in 2012-16, we expect the US economy to slow to 1.7% over 2017-21,” said Juckes.
More analysis shows that it is not just slowing growth which is the problem but the lack of growth despite low unemployment, which taken together suggests the people working are not being very productive.
And it is this lack of productivity which will seal the Dollar’s fate.
“Over the past 50 years, US employment growth has averaged 1.7% per annum, close to the ‘disappointing’ 1.6% growth in employment we saw in May,” says Juckes, but previously growth was strong at 2.8% on average.
The difference is now in the growth, which has dropped to 2.0% (Mar) despite the strong employment figures.
How to explain this lack of growth despite so many people working?
Juckes suggests it is a reflection of a lack of productivity.
“The US is generating 2.0% GDP growth from 1.6% job creation, and there’s little reason to believe that gap (productivity growth) will start widening again without any policy moves to encourage it,” he concludes.
