Euro-Dollar Week Ahead: Once More Unto the Breach as USD Sentiment Dominates

- EUR seen advancing to new 2-year highs as USD unravells.
- Move above 1.2015 could see EUR target 1.2635 2018 high.
- But gains risk ECB scrutiny, could render EUR an FX laggard.

Image © Adobe Images

• EUR/USD spot rate at time of writing: 1.1907
• Bank transfer rate (indicative guide): 1.1490-1.1574
• FX specialist providers (indicative guide): 1.1728-1.1800
• More information on FX specialist rates  here

The Euro-to-Dollar exchange rate returned to its front foot last week and could attempt to better its existing two-year high in the coming days if bearish sentiment toward the U.S. greenback builds further, although Europe's unified unit might risk becoming a bit of a laggard among other major currencies. 

Dollars were sold en masse after the Federal Reserve (Fed) said on Thursday it will deliberately foster above-target inflation and that interest rates will still remain pinned to the floor as price pressures rise. Previously above-target inflation could've been likely to incite an interest rate rise but now the Fed says it will leave rates at record lows to actively foster above-target inflation in order to make amends for past as well as present periods where the bank has fallen short of the objective for 2% price growth. 

The policy shift was in line with what many analysts were expecting but implies further falls in the 'real' bond yields, or inflation-adjusted returns earned by investors, that were widely cited as being behind declines in the Dollar over recent months as well as late last week. Investors' extreme bearishness on the Dollar, combined with gains in GBP/USD and falls in USD/JPY, could offer the Euro-to-Dollar rate another opportunity to get past 1.1965 in the week ahead. 

"EUR/USD keeps knock knock knockin’ on 1.20s door but has so far failed in every attempt before getting (too) close. It is probably just a matter of time before it happens, but the ECB will have a clear interest in fighting it short-to-medium-term since the European inflation is yet way too fragile," says Andreas Steno Larsen, chief FX strategist at Nordea Markets. 

Euro-to-Dollar rate gains and losses for other currencies have all helped to lift Eurozone's trade-weighted exchange rate back to the lofty heights seen in 2017, which is a headwind for the Eurozone economic recovery and an outright risk to the bloc's inflation outlook. A stronger trade-weighted currency means the all-important Eurozone exports become less competitive and also works to offset the very inflation pressures the European Central Bank (ECB) is attempting to foster with its monetary policy.

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

"Provided that dips remain well supported by the 1.1673/61 area (a double Fibonacci retracement) and the 3 month uptrend at 1.1662, an overall upside bias is maintained," says Karen Jones, head of technical analysis for currencies, commodities and bonds at Commerzbank. "Above 1.2015 will introduce scope for further gains to 1.2635/66."

Some are not so worried about the economic impact of a strong Euro although others including Nordea's Larsen see an eventual break above 1.20 as likely to incite rhetorical intervention from European Central Bank policymakers that could ultimately serve to constrain the single currency in its advance.But with the Euro uptrend intact so long as it's above 1.16 and the market increasingly bearish in its Dollar outlook, ECB intervention might mean only that the Euro becomes a bit of a laggard among major currencies.

"A client asked us “If Christine Lagarde did a "Powell" and promised an average 2% inflation over time, would you then laugh or cry?” That is a good question," Larsen says. "Core inflation is en route for new post 2000-lows according to our model framework. With an average core inflation below 1%, would anyone even take it barely seriously if Lagarde were to announce an AIT regime in Europe? Probably not. It will likely not be enough to dissuade Lagarde from trying and it wouldn’t be a surprise to us if the ECB policy review (ETA is currently mid-2021) included a move towards AIT, even if it would be almost hilarious to watch such a press conference."

The ECB has rarely met its inflation target of "close to, but below 2%" since the financial crisis and its track record is even worse when 'core inflation,' the market's preferred measure, is taken in place of the consumer price index.

This is part of why Nordea sees a risk of the ECB turning to the same inflation strategy adopted by the Fed last week. The bank says that's a reason to expect the Euro to remain below 1.20 but doesn't rule out a Euro break above there. 

However, there's a silver lining for the single currency in the current Dollar bearish market, which could enable EUR/USD to rise without lifting the trade-weighted currency in the same way as it has done before. Further gains in GBP/USD and any additional falls in USD/JPY would lean against the trade-weighted Euro, enabling EUR/USD to rise. 

Above: Euro-to-Dollar rate shown at weekly intervals alongside USD/JPY rate (black line, left axis). A falling USD/JPY rate puts pressure on the trade-weighted Euro.

"Rrecall that high nominal and real dollar rates were the key ingredients behind USD strength in prior years)," says Petr Krpata, chief EMEA strategist for currencies and bonds at ING. "Despite plenty of good news being priced into EUR (the agreement on the EU Recovery Fund and the new budget led to a compression of the EZ fiscal premia) and speculative positioning being stretched, the dollar weakness dominates and is likely to be the key driver of the cross next week and for quarters  to come. With the soft USD environment in place, the risk is skewed for modestly higher EUR/USD next week."

The Euro-to-Dollar rate enters the new week trading above 1.19 having failed to establish a new high in the U.S. Dollar sell-off on Friday, while investor attention will be on Dollar sentiment as well as a handful of economic releases from both sides of the Atlantic. Tuesday's Eurozone inflation figures for August are the highlight of the European calendar followed by July retail sales at 10:00 on Thursday. Consensus is looking for Eurozone inflation to have risen at an annualised rate of 0.2% this month, down from 0.4% previously. Core inflation is seen rising by 0.9%, down from 1.2% previously. Meanwhile retail sales are expected to have risen 1.3% in July after gaining 5.7% in June. 

Meanwhile, the highlight of the U.S. week is the non-farm payrolls report that's due at 13:30 on Friday. However, before then the Institute for Supply Management (ISM) manufacturing PMI is out Tuesday at 15:00 and the non-manufacturing (services) PMI is out Thursday at 15:00. Consensus looks for the manufacturing index to rise from 54.2 to 54.5 while markets see the services index falling from 58.1 to 57.5. The market envisages a 1.5 million increase in new jobs from the payrolls report, which is expected to push the unemployment rate down from 10.2% to 9.8%.

"Relative real, nominal, long and short-term rates have moved sharply against the dollar and longer-term growth expectations have too," says Kit Juckes, chief FX strategist at Societe Generale, who looks for a EUR/USD rate of 1.18 at year-end. "All good reasons to be bearish of a dollar which, in both real and nominal terms, is very stretched and indeed, has corrected relatively little so far. Our doubts, about whether the dollar can suffer a broad-based fall in the midst of risk aversion, global recession and particularly emerging market weakness, have been blown aside by the Fed (and the US equity market). Our updated forecasts reflect our concern that EUR/USD in particular, has gone too far too fast, but it seems clear to us that we are at the start of a multi-year period of dollar decline, from very elevated levels."

Above: Euro-to-Dollar rate shown at weekly intervals alongside Dollar Index (black line, left axis).