Euro-to-Dollar Rate: J.P. Morgan Reiterates Bearish Forecast as Market Awaits EU Commission's Verdict on Italian Budget

© European Central Bank

- EUR to trade on back foot into year-end say J.P. Morgan.

- Cites Italian budget fallout, ongoing outperformance of USD.

- But tables turn in 2019 as growth, currency trends go into reverse. 

The Euro will fall back to its joint lowest level since June 2017 before the year is out, according to forecasts from analysts at J.P. Morgan, who are warning that a strong U.S. Dollar and upset over Italy's budget plan will keep the single currency on the back foot in the months ahead. 

Italy's national budget plan for the 2019 year was submitted to the European Commission for approval Monday and markets now await an almost-inevitable rejection of its spending proposals that could push Rome and Brussels into conflict with each other. 

Renewed focus on Italy comes seven months after a general election swept anti-establishment parties into power in Rome and as the Dollar remains enjoys a renaissance thanks to a U.S. economic performance that has been superior to that seen anywhere else in the developed world this year.

"The end-2018 projection for EUR/USD is modestly lower and predicated on a combination of 1) continued divergence in near-term macro-economic momentum between the US and the Euro area and 2) probable further tensions over Italy’s budget if, as seems likely, this is rejected by the EU Commission," says Paul Meggyesi, head of currency strategy at J.P. Morgan. 

The Mediterranean country's coalition government was elected on pledges to role back some forms of earlier austerity, implement new welfare programmes and to cut taxes. But rules contained in the EU's Maastricht Treaty, which all member states have signed, give the commission far reaching powers over the government spending of individual nations. 

Brussels can demand an alternative budget and set the ball rolling on a sanctions procedure if Italy does not comply. However, given the electoral climate, this would risk stoking anti-Euro sentiment in Italy and potentially endangering the nation's place as a member of the single currency bloc.

"In our judgement Italy's fiscal plans are liable to remain a tactical hazard for the euro, at least over the coming four-six week period. The government has set itself up for conflict with both the EU Commission and bond investors having opted for a marked increase in the 2019 deficit from 1.8% this year to 2.4% in 2019," Meggyesi warns.

Most analysts expect that Brussels and the new government in Rome will eventually develop a working relationship but this won't stop the Euro from suffering as and when tensions flare up. And most of those are expected to be given their best airings during the period running through November. 

Meggyessi and the J.P. Morgan team forecast the Euro-to-Dollar rate will finish the 2018 year at 1.13, which would be down from 1.1580 on Tuesday and its joint lowest level since June 2017. 

"Beyond that, we continue to expect a progressive but nevertheless shallow uptrend in EUR/USD through next year to 1.19 to reflect 1) a closure of the growth gap between the US and Euro area from 1.5% so far this year, and 2) a probable improvement in rate spreads in the euro’s favour," Meggyesi adds. 

The strong Dollar that has kept the Euro-to-Dollar rate on its back foot in recent months is a byproduct of stimulus-powered growth in the U.S. that has enabled the Federal Reserve (Fed) go on raising its interest rate while the European Central Bank only contemplates an eventual change to the setting of its own benchmark.

However, the J.P. Morgan team says this pattern should go into reverse once into 2019, along with the trend in the Euro-to-Dollar rate, as U.S. growth slows and the Eurozone economy picks up.

This could lead markets to conclude that the Federal Reserve tightening cycle is ending just as the process of policy normalisation gets started in Europe, although the latter will depend on an improvement in the inflation outlook. 

Eurozone inflation rose by 2.1% during September according to Eurostat, up from 2%, which reverses the 10 basis point decline seen back in August.

But core inflation, which ignores prices of some commodities and so is thought to provide a better reflection of domestically generated price pressures, posted a surprise 20 basis point fall to a five-month low of just 0.9%.

The jury is still out on whether domestic price pressures will return next year but the ECB is required by law to use monetary policies to ensure inflation remains "close to but below 2%". 

Changes in interest rates are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

J.P. Morgan is betting core inflation picks back up again next year and that this encourages a climb by the single currency to 1.19 against the U.S. Dollar. 

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