EUR/USD Undervalued, Likely to Rise: BofAML

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- EUR/USD is undervalued and likely to drift higher

- Cross-currents make the analysis more complex

- U.S. economy stronger than Eurozone for example

The Euro-to-Dollar exchange rate is likely to rise eventually because it is undervalued, says Thanos Vamvakidis, head of G10 FX at Bank of America Merrill Lynch, despite complex cross-currents muddying the outlook for the pair.

“This is an extremely difficult call to make. There are many offsetting forces. We are still constructive on the Euro, we have it at 1.17 by the end of the year based on valuation arguments,” says Vamavakidis in an interview with Bloomberg News.

According to one valuation the EUR/USD ‘equilibrium level’ - the level it should naturally be at were purse economics taken into account - is 1.20-1.25 says Vamavakidis, yet the Euro has other factors dragging it down.

The main one of which appears to be worse data and a more dovish monetary policy outlook.

“But it is actually very tough to have a strong call on the Euro. Both the Fed and the ECB are about to ease. The Eurozone data is actually weaker than the U.S. and justifies more easing but the Fed has more room to ease than the ECB,” says Vamvakidis.

The Federal Reserve (Fed) chose to cut rates by 0.25% at its meeting on Wednesday whilst the European Central Bank (ECB) chose not to cut rates and its meeting last week.

Usually, this would have helped the Euro versus the Dollar given interest rates are highly correlated to currencies since they drive up net foreign capital inflows, but not in this case.

The discrepancy can be put down to the more negative longer-term expectations for the ECB: although they did not actively cut rates they hinted they would cut them in the future and that was enough to weaken the Euro.

In the case of the U.S. Dollar, meanwhile, the cut by the Fed was seen as more of an ‘insurance cut’ against possible future weakness rather than a reaction to actual weakness.

“The market is pricing a high probability of the beginning of an easing cycle while the Fed right now is delivering insurance cuts to address risks to the outlook rather than negativity in the outlook,” says Vamavakidis.

The EUR/USD call rests on valuation arguments alone as Vamvakidis is actually much more optimistic about the U.S. economy than the Eurozone economy.

Talking before the Fed cut interest rates by 0.25% on Wednesday, he said: “I think even the 25 basis points is a policy mistake. The U.S. economy is not weak enough. The data actually is good. The U.S. economy is growing above potential. Inflation is broadly at the target.

According to some measures slightly below, according to some measures slightly above, and the Fed is wasting limited ammunition.”

Contrast this to his view of the Euro: “We have a number of risks for the Eurozone in the coming months: Brexit, the Italian budget, the trade negotiations between the U.S. and the EU.”

The risks to the Eurozone economy from a hard Brexit have not been fully digested by the Euro either, says the strategist.

“The Euro is underestimating the potential implications on the European economy if there is a no-deal Brexit.”

Yet the U.S. Dollar also has negative headwinds. The U.S. administration does not like a strong Dollar, for example, and the threat of intervention is increasing.

“So you have all these mixed forces and it is very difficult actually to have a hard view on the Euro. This is why EUR/USD remains undervalued,” says Vamvakidis.

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