The Euro-to-Dollar Rate will Recover Lost Ground in 2019 says Bank of America

© Grecaud Paul, Adobe Stock

- EURUSD to recover all of 2018's loss in 2019 says Bank of America.

- As U.S. growth slows and Eurozone economy stabilises at "potential".

- But U.S.-China trade deal and smooth, orderly Brexit are prerequisites. 

The Euro will recover lost ground from the Dollar in 2019, according to forecasts from Bank of America Merrill Lynch, as U.S. economic growth moderates following a year of exceptional outperformances. 

The U.S. economy will cool as the tax cuts that boosted it in 2018 begin to lose their lustre, the bank says. And as growth returns from an inflationary "above-potential" rate back to a level closer to "potential", the Dollar is expected to decline from an overvalued level back toward its equilibrium. 

That should mean the monetary policy divergence that saw the Federal Reserve (Fed) raise its interest rate four times in 2019, while the European Central Bank (ECB) sat on its hands contemplating an uninspiring Eurozone inflation picture, becomes a story of convergence. 

This is important because earlier divergence had created a strong incentive for investors to sell Euros and buy Dollars with the proceeds during 2018. Fed policy had meant that by the end of the year, short-term U.S. government bonds paid their investors as much as 3.5% more than their German counterparts.

Above: Spread, or difference, between interest paid by 2-year U.S. bonds and 2-year German bonds.

"Our main thesis for this year is that, to the extent that the US fiscal stimulus weakened EURUSD in 2018, EURUSD should strengthen as the impact of the US fiscal stimulus fades. We are assuming that by the end of the year the Eurozone and the US will be growing at potential and monetary policies will start converging," says Athanasios Vamvakidis, a strategist at Bank of America, in a note to clients. 

U.S. economic growth reached 4.2% during the second quarter of 2018, a four-year high, after White House tax cuts lifted business investment and consumer spending. Those cuts slashed the corporate tax rate by nearly half and handed an estimated $1,200 in annual income back to the average household.

Meanwhile, the Eurozone economy slowed markedly in 2018, with quarterly growth falling from 0.7% in the final three months of 2017 to just 0.4% in the first and second quarters.

Third quarter Eurozone GDP grew by just 0.2%, although preliminary figures for the final quarter and year overall will not be released until the end of January.

"US growth peaked in Q2 2018 and is already slowing. Although the US continues growing above potential, our economists expect the US to be growing at potential by the end of this year," Vamvakidis writes. "The fiscal stimulus pushed the US economy above potential and the USD above equilibrium. Our thesis suggests that as the impact of the fiscal stimulus fades, US growth will go back to potential and the USD back to equilibrium."

Above: EUR/USD (red & blue) with 2-year U.S.-German bond yield spread (orange) overlay.

Vamvakidis says Bank of America's call for a EUR/USD recovery in 2019 makes a number of large assumptions, including that the UK avoids a so-called no deal exit from the European Union and Italy's stand-off with the European Commission remains under control.

He is also banking on the idea that Eurozone growth stabilises rather than continues to decline and that the U.S. and China agree a deal to end the so-called trade war between the two. EU parliamentary elections in May are also a pocket of risk for the single currency. 

Bank of America's economists say the Eurozone expansion likely reached its nadir in the final quarter and that, assuming no further "shocks" are felt by the economy over coming months, growth should stabilise before year-end. 

"Expecting growth in the Eurozone and the US to be at potential and ECB and Fed monetary policies to start converging by the end of the year, we are forecasting EURUSD to move back to its long-term equilibrium. We expect EURUSD at between 1.20 to 1.25 this year and at 1.25 by the end of the year," Vamvakidis writes.

The Euro-to-Dollar rate was quoted 0.39% higher at 1.1437 during the morning session Monday but is down by -0.25% for the 2019 year. The exchange rate declined by -4.2% in 2018, finishing the year at 1.1433 when it had been as high as 1.2551.

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