Euro-Dollar Can Pass 1.20 withouth Drawing ECB Ire says Goldmans

- EUR/USD whipsaws in volatile trade as Fed, U.S. hit wires.
- USD correcting higher but EUR rally seen intact above 1.15.
- Goldman Sachs sees ECB unfazed by 2020 EUR strength.
- Nordea flags 1.20 as a likely ECB line in sand this Autumn.

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The Euro's 2020 rally against the U.S. Dollar can endure without the single currency drawing the ire of the European Central Bank (ECB), according to new research from Goldman Sachs, although others see the 1.20 threshold as a potential line in the sand for Frankfurt.

The 6.48% rise seen in EUR/USD thus far in 2020 has, when combined with an even larger 6.8% increase in EUR/JPY, lifted the trade-weighted single currency back to levels seen in 2017 when the Euro rallied by a double-digit percentage from 1.06 in April to near 1.20 against the Dollar by year-end.

An elevated trade-weighted index is an headwind for the export-heavy Eurozone economy as it seeks to recover from the collapse brought on by government attempts to contain the pneumonia-inducing coronavirus, and it's also a disinflationary headwind for an inflation-targeting ECB.

Stronger exchange rates counteract inflation by reducing import costs for companies, and the ECB has rarely met its inflation target of "close to, but below 2%" since the financial crisis.

"We find that an exogenous 10% trade-weighted Euro appreciation typically reduces real GDP and consumer prices each by around 1% after two years. This rule of thumb implies that the appreciation so far might lower growth and inflation by about ¼ percentage point in each of the next two years," says Sven Jari Stehn, chief European economist at Goldman Sachs, before noting that such growth headwinds are minuscule compared with the 7.1% rebound anticipated by the bank for next year.

Above: ECB estimates of Euro relative to 19 largest Euro area trading partners and 38 largest trading partners. Blue and yellow lines show higher frequency estimates testing 2017 highs while brown and purple lines show lower frequency measures rising back to pre-ECB quantitative easing highs. Estimates dated July 01, 2020.

"Our markets team expects the Euro to strengthen further from here - to 1.25 against the Dollar in twelve months and roughly 2.5% on a trade-weighted basis—as we expect the Euro area economy to outperform other countries and see the Euro as under-owned in international portfolios and under-valued in our fair value models," Stehn says. "EUR appreciation primarily reflects an improvement of the economic outlook and constructive institutional change in the Euro area’s fiscal architecture. The stronger Euro is, therefore, unlikely to be a significant concern for the ECB at this stage." 

Eurozone inflation has held below 2% for the best part of the last decade and more so if core inflation is takebn as the more appropriate measure. The latter normally garners more attention from the market because it ignores energy, food and regulated price changes and so is thought to better reflect domestic and organically generated price trends. 

ECB policymakers are already scrutinising the rally closely, with minutes of the mid-July meeting revealing last week that the bank saw it reflecting "the removal of tail risks and the comparatively successful containment of the coronavirus in Europe," although then EUR/USD had yet to scale above the 1.14 level and has since risen to trade almost as high as 1.20. The Euro-to-Dollar rate was briefly quoted at 1.1965 on Tuesday, 18 August. 

"We have argued over the past weeks that it is too early for >1.20 readings in EUR/USD unless Powell opts to hint of further Japanification-measures," says Andreas Steno Larsen, chief FX strategist at Nordea Markets. "The ECB is by the way probably not ready to accept >1.20 levels without a battle either. They managed to temporarily temper the EUR/USD momentum in August and September 2017 when sources kept leaking stories to Reuters and Bloomberg every time 1.20 was breached. We are on alert of a similar rhetorical intervention from Frankfurt should the EUR/USD gain too fast again." 

Above: Euro-to-Dollar rate shown at weekly intervals.

Europe's single currency was more than half a percent lower against the greenback Thursday after having whip-sawed in noon trading when investors attempted to digest a landmark speech from Federal Reserve (Fed) Chairman Jerome Powell alongside upgrades to Bureau of Economic Analysis' second quarter growth estimates for the U.S. economy.

American pending home sales data was also strong, with in-progress transactions rising 5.9% in July after a 15.8% increase in June.

Jerome Powell confirmed the Fed will shift to a so-called average inflation targeting regime where the bank keeps interest rates lower for longer in order to make up for past overshoots, although the address and details of the policy were littered with caveats the reaction from financial markets was duly mixed. 

The Dollar was eventually found heading higher alongside U.S. yields and the Euro lower, matching bond yields on the continent, although price action was choppy and the accompanying economic data may have complicated perceptions of the market's verdict on the Fed's new policy bag. 

"The change means that the central bank will be more willing to stimulate the economy even as the unemployment rate falls, specifically leaving the fed funds rate at the effective lower bound for longer than previously expected. The market had been anticipating such a change, and rates actually moved lower after," says Royce Mendes, an economist at CIBC Capital Markets. 

The Bureau of Economic Analysis upgraded its second quarter GDP estimate Thursday, lifting it from an annualised -32.9% to -31.7% when the economy had already declined less than was the case in the Eurozone during the period when the GDP contraction is represented in quarter-on-quarter format. The BEA does not publish GDP numbers in anything other than annualised format although Federal Reserve Bank of St Louise data suggests the fall was -9.1% when Eurostat has penciled in a -12.1% contraction for the Eurozone economy.

Europe's single currency tumbled Thursday but was still comfortably above 1.17 while the EUR/USD uptrend remains alive and well while the market is above 1.15, according to some analysts. 

Many expect the Euro to build further on that rally in the year ahead while Goldman Sachs research suggests this is unlikely to concern the ECB just yet.