Deutsche Bank Forecast EUR/USD to Reach Parity on USD Funding Demands

Funding costs are another fundamental reason why the euro to dollar exchange rate (EURUSD) may reach parity according to a new analysis. 

Deutsche Bank euro to dollar trade

The euro retains a perky tone agianst the US dollar with EURUSD managing to hold the 1.07 region at the time of writing.

However, medium- to longer-term pressures continue to build and one can only assume any strength will be short-lived.

Researchers at Deutsche Bank, one of the world's largest currency trading institutions, have argued that the rising cost of US dollar funding will be a dollar-supportive driver beyond the widely understood central bank divergence story.

The euro / dollar exchange rate has fallen below the key support level of 1.10 in the wake of a shift in central bank policy which sees the US Fed looking to raise interest rates and the ECB looking to cut interest rates further.

In a note to clients Deutsche observes, "over the last few weeks the cross-currency basis, representing the additional cost of borrowing dollars in the FX swap market over and above the rate differential, has ballooned to the highest since 2011".

Deutsche Bank single out four rationales:

Widening Against Multiple Currencies

Analysts observe the widening is now occurring against multiple currencies; whereas in previous times this happened mostly against the EUR or Japanese Yen.

The widening basis does not seem to be driven by rising credit risk, similar to the Eurozone and Lehman crisis. Credit metrics such as the USD Libor-OIS spread have remained well-behaved, for the most part.

Widening Goes Beyond Traditional Year-End Funding Constraints

Deutsche Bank observes the widening appears to go beyond traditional year-end funding constraints after observing an even longer-dated cross-currency basis has widened out.

US Rates May Be Rising While Everyone Else Is Near Zero

The cross-currency basis in coming at a time when everyone else’s rates are near zero or set to be cut, while the US rates are expected to rise for the first time since the end of the financial crisis.

The bank argues this is important because the low starting point of rates means the proportionate impact of a widening basis on the rate differential has the potential to be huge.

Using the Japanese Yen as an example, the bank notices the recent basis widening is equivalent to a 30% increase in the short-term rate spread.

Concerning prospective strategies this research presents for the euro to dollar exchange rate, Deutsche Bank conclude:

"Overall, a combination of year-end funding constraints, lack of liquidity, regulatory pressure and precautionary demand for dollars ahead of FOMC liftoff seem to all be driving the move in the basis. The observations above suggest anticipation of the latter may be playing a greater role than usual and as a result the moves may have more persistence than in previous episodes.

"This adds to the bullish dollar view, on top of the fact that traditional metrics such as the real rate differential already point to a move down to parity in EUR/USD."

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