EUR/USD: Lloyds Forecast Exchange Rate Recovery in 2016

Lloyds target a move in EUR/USD to 1.04 by end year and to 1.02 by end March, but a move below parity cannot be ruled out.

Since the strong labour market report for October, the market has largely priced in a first interest rate hike by the Fed in December.

As a result, USD appreciation has recently started to falter and forecasts from HSBC suggest the dollar could fall further in 2016.

Nevertheless, the USD maintains the momentum - the euro to dollar exchange rate reached a recent high of around 1.15 in mid-October and has since fallen to a low below 1.0650.

Conflicting news on US and euro area monetary policy have pulled the euro and the US dollar in opposing directions.

In the US, minutes from the November meeting have left markets convinced that  the Fed will raise interest rates next month for the first time since June 2006.

At the same time, the ECB has hinted that further policy stimulus (both QE and a policy rate cut) may be on the cards when it delivers its December policy decision.

Although financial markets are now broadly priced to both these outcomes, we believe the prospect of heightened ECB/Fed policy divergence leaves the euro vulnerable to further downside over the coming months,” say Lloyds Bank in a recent note to clients.

Lloyds target a move in EUR/USD to 1.04 by end year and to 1.02 by end March, but a move below parity cannot be ruled out.

Thereafter, Lloyds say they are constructive on the euro on fundamental grounds.

“But amid rising US interest rates, the prospect of any significant euro recovery through 2016 is, we believe, limited. We target a rise back to 1.10 by the end of next year,” say Lloyds.

A good chunk of Lloyds’ euro to dollar forecast therefore rests with action being taken at the ECB. While the question of “how much” is dominating the discussion in the US, it’s more about the question of “what” in the euro zone.

Euro Recovery Won’t be Sustained

ECB chief Mario Draghi pointed out after the last meeting that the ECB can further loosen monetary policy in various ways.

One option is an adjustment of the bond buying programme; another option is to lower the deposit rate.

“Next week, ECB Governing Council members will have their last opportunity before the meeting in the following week to make a statement on the measure they prefer,” notes Thu Lan Nguyen, an analyst with Commerzbank.

Depending on how cautious or aggressive they are, this could trigger some strong movement in EUR exchange rates. In the medium to long term, however, their target will definitely be to weaken the EUR in general to create inflation.

“Consequently, any possible recovery in the EUR will not be sustained,” says Nguyen.

Dollar Weakness?

But it won't be all plain sailing for the US dollar in the year ahead either.

Since the strong labour market report for October, the market has largely priced in a first interest rate hike by the Fed in December.

As a result, USD appreciation has recently started to falter.

US data up to the December meeting would have to be hugely disappointing to trigger renewed market doubts about the lift-off. Rather, the focus is increasingly on the question of what will happen after that.

"FOMC members are not tiring of stressing that the key interest rate will be raised in this cycle at a much slower rate than in earlier cycles. Consequently, only two further rate hikes are being priced in by the market for 2016," says Nguyen.

Strategist David Bloom at HSBC believes the narrative on the US dollar bull cycle is starting to turn - from a pro-USD focus on the timing of the first interest rate rise to a more negative-USD focus on the final level of interest rates.

If the markets see the Fed rate-rising cycle as being too shallow the US dollar could well struggle in 2016.

If this occurs just as the Eurozone's economy kicks into a higher gear the euro to dollar exchange rate could make some decent gains towards the end of 2016.