Euro / Dollar Rate to Remain Pressured as Markets Question a post-Brexit Future

The EUR to USD exchange rate has fallen back to 1.12 as markets ask what a potential UK exit from Europe poses for the future of the European Union, Eurozone and shared currency.

• ING report a widening in the EUR/USD cross currency basis swap, suggesting that USD funding costs are increasing
• Danger that euro could become more negatively aligned with brexit risk warn Credit Suisse
• 1.16 target maintained for coming weeks by BNP Paribas

The euro is forecast to remain pressured as traders turn shy on the shared currency in anticipation of a potential UK exit from the European Union.

This comes after a major British tabloid came out in favour of the Leave campaign and recent polls have pointed to a rising probability of a departure from the EU.

“Considering it became a notion that the EUR will be among the main losers in a Brexit scenario, the currency may become more negatively correlated with risk sentiment,” says Valentin Marinov, Head of G10 FX Strategy at Credit Agricole.

A Brexit could indeed be a big deal for the euro / dollar with one analyst telling us that such an event would ensure the pair falls to parity.

National Australia Bank's Nick Parsons argues that if he is right, and the pound goes to 1.28 against the dollar, that gives you euro-dollar at parity.

“I can divide 1.28 by 1.28,” says Parsons. “Euro / dollar at parity is what I think will happen if the UK votes to leave the EU.”

NAB believe that Brexit is as big a threat, if not more of a threat, to the single European currency than it is to the UK.

And, there will be no snap-back recovery bounce for EUR/USD. “I think it will retain those kind of levels.”

“What do you want to hold, I don’t want to hold euros, I don’t want to hold sterling, the dollar by default will be rising,” says Parsons.  

US Funding Costs Increasing, Could Pressure EUR/USD Further

The widening of the EUR/USD cross currency basis swap is also catching market attention.

The widening now suggests that USD funding costs are increasing – just as they did during the 08/09 crisis and again periodically during the Greek crisis. When this occurs it suggests borrowers are looking to minimise exposure to the euro which could fluctuate wildly.

In short this is a symptom of declining confidence in a currency.

However, analyst Chris Turner at ING says he feels that banks were now much better balanced in terms of FX assets and liabilities.

Turner and his team also feel these banks did not have the same USD shortages as were seen in 2008/09, based on BIS data.

"But recent move suggests there may be some precautionary USD funding taking place - and suggests the USD could strengthen a little further ahead of the referendum," warns Turner.

EUR/USD to Turn Attention to the US Fed

Brexit aside, we have the all-important June edition of the Federal Reserve Open Market Committee (FOMC) meeting due mid-week.

The FOMC is significant in that it will give traders a better sense of just when the Fed intends to deliver that next interest rate rise, and therefore the dollar will react.

Most analysts are now in agreement that the FOMC is unlikely to adjust policy or signal a move in June or July courtesy of the soft US employment report released on Friday the 3rd of June.

Nevertheless the EUR/USD should be bucked by the information and forecasts released by the Fed; no doubt market participants will focus on the dot plot evolution and to look for evidence that the Fed is becoming less confident in the economic outlook.

Each dot on the chart is the interest rate level at which each voting member believes the Fed rate should be at the end of this year, and the next few years. Essentially, any shifts higher in the dots signal a more agressive sentiment on interest rates which would be deemed positive for the dollar.

“The FOMC statement and Janet Yellen's press conference will still rock the dollar because investors are on the fence about the timing of the next rate hike,” says Kathy Lien, an Director with BK Asset Management.

Lien says if Yellen refrains from saying that rates could rise in the coming months and expresses concerns about the economy, the dollar will extend its slide. 

But if Yellen is even slightly more hawkish than the market expects, the dollar will rise quickly and aggressively.

“The message is likely to mirror Fed Chair Janet Yellen’s Philadelphia speech, emphasising a need to wait and see whether the slowing in jobs growth is part of a broader deterioration, while still signalling an expectation that rate hikes will resume later this year,” says a note on the matter released by BNP Paribas.

BNP Paribas believe that data out this week will also be underwhelming, and when combined with a cautious Federal Reserve, the EUR/USD is likely to head higher on USD softness.

BNP Paribas are forecasting the euro to edge higher towards 1.16 in the weeks ahead.

Back to 1.12

We see that 1.16 as quite an optimistic forecast for the euro / dollar rate, particularly now the shared currency is being seen as a likely casualty of a UK vote to leave the European Union.

The market implied probability of a 25bps rate hike by the September meeting has fallen
from over 60% in late May to around 30%.

"In our view, this looks overdone. If, as we expect, the US economy rebounds in Q2, jobs growth improves and inflation continues rising towards 2%, the Fed is likely to tighten policy in the second half of the year," says a note from Lloyds Bank.

Based on this, we expect EUR/USD to drift lower, ending the year around 1.12