Euro / Dollar Forecast Lower in 3 Months by Danske Bank, Higher by Morgan Stanley

We present contrasting views on where the Euro to Dollar exchange rate (EUR/USD) might go in both the short-term and the long-term.

The EUR/USD conversion remains well contained within its 2015-2016 range, defined by 1.1450 to the top and 1.05 at the bottom.

It would seem however that the exchange rate is in the process of revisiting the bottom end of the range on speculation that a Brexit-inspired slowdown will potentially force the European Central Bank (ECB) to accelerate their asset purchase programme.

It is after all a determined era of interest rate cutting and asset purchases at the ECB that has propelled EUR/USD to these multi-year lows. 'More of the same' willl ensure the pair remains anchored in this region.

But, the Euro will eventually rise over a 12-month horizon, propelled by the region’s vast Current Account surplus, says Thomas Harr, Global Head of FICC Research at Scandinavian lender Danske Bank, in his latest set of forecasts.

The current account of the Eurozone saw a surplus of €36.2BN recorded in April 2016 confirming the area continues to export more than it imports; this suggests a fundamental demand for Euros from external trading partners that should keep the currency underpinned.

Compare this to the UK which has a gaping current account deficit, one reason why a host of foreign exchange analysts have warned the Pound Sterling faces increasing downside preasures. 

“Short-term, we expect increased political uncertainty in the Eurozone and the prospects of further monetary easing to weigh on EUR/USD. However, medium-term we continue to expect that the undervaluation of the EUR and the large eurozone-US current account differential will support the EUR,” says Harr.

Harr and his team have nevertheless downgraded their forecasts for EUR/USD owing to the UK's decision to exit the European Union. 

The potential for further rate cuts and an increase in the asset purchase programme at the ECB, in response to political uncertainty, justify the downgrades.

Analysts see the pair trading at 1.09 in one month (1.11 previously), 1.07 in three months (1.10 prev), 1.10 in six months (1.14 prev) and 1.14 in 12 months (prev 1.18).

Morgan Stanley’s strategist Hans Redeker takes an opposing view however and strikes a more upbeat tone on the single currency over the near term.

Redeker believes the euro will strengthen in the short-term before weakening in the long-term -  an almost mirror opposite of Harr’s conclusions.

Whilst both see a threat to the Euro from the ECB increasing its stimulus programme they differ in their assessment of the likelihood of this happening, and also in the type of ECB measures employed.

Harr must see a relatively high chance of the ECB increasing stimulus in the short-term, but for Redeker the probabilities are lower at least for the ECB reducing interest rates, although there may be a chance they might widen and lengthen their QE programme.

The distinction is important, as for Redeker, the ECB lowering interest rates (presumably deposit rates) is likely to have a deeper impact on the currency than increases to the duration and scope of its asset purchase programme.

“The ECB's interest rate policy has a larger impact on the currency than its QE programme. It was the expectation of future rate cuts into negative territory that pushed EURUSD from 1.40 to 1.05. The market has already priced another 10bp cut by year end, suggesting that the ECB would need to go even deeper into negative territory for the EUR to weaken and of course this is a risk to our currency view.”

There is already evidence of this from the March meeting, where the euro started falling after the announced a deposit rate cut but then halted after Draghi’s subsequent comments at the press conference that these were as low as rates would go.  

The reason Redeker sees very little chance that the ECB will cut rates further is due to the negative impact such a move would have on euro-area commercial bank profitability.

This is because banks cannot pass on the cost of negative rates to their customers so it erodes their margins.

In the case of Eurozone banks the situation is exacerbated by the fact that the interest they used to earn from deposits with the ECB, was a major source of their revenue, because other sources such as returns from lending dried up in the crisis. This was reflected in the high percentage of non-performing loans carried by many Eurozone lenders.

Taking away the revenue they earned from depositing money with the ECB has further squeezed their margins.

“Given the impact of negative interest rates on bank balance sheets, a further decline in short-term rates may undermine bank profitability and implicitly the willingness of banks to provide credit. The consequently weaker credit multiplier may be a too-high price to pay for putting this policy in place. We could easily enter a situation where falling bond yields no longer compensate for falling inflation expectations. Real yields would rise, pushing the EUR higher.” Said Redeker.

This view is supported by recent comments from the ECB’s chief economist and council member Peter Praet, who himself raised concerns about the impact of negative rates on Eurozone banks, (the quote below is from a report in the Telegraph):

“Peter Praet said that “the profitability of the sector will be a key consideration” in assessing how the central bank can help to stimulate the euro area economy.”

The plight of Eurozone banks was exacerbated by Brexit which triggered a sell-off in bank shares and precipitated the Italian banking crisis, which is still currently unresolved.

The reason why the more likely ECB policy response of increasing QE is unlikely to have as deep an impact on devaluing the euro, is because the most likely source of new bond purchases is the corporate sector since sovereign bond supply is so low, however, according to Redeker corporate bonds are less effective at bringing down the exchange rate:

“Expectations for expansion of the QE programme, which is a probable next step for the ECB, are now unable to weaken the EUR as the movement towards corporate bond purchases is not effective at bringing down long term government bond yields, which the currency responds to most.”

Another argument from Redeker for seeing the euro rise in the short-term is the threat of deflation which leads investors to ‘disinvest’ - that is nbot reinvest their principle - as yields fall below zero, because at that point it is more worthwhile for them to stay in cash. As a result this tends to lead to an appreciation of the currency:  

“With the 10y German Bund now yielding below zero, it is more difficult for bond yields to fall in response to any growth shock to the economy. As a result, currencies are unable to weaken in response to growth weakness. Similarly, investment returns globally have fallen further, meaning that the propensity for an Eurozone investor to send money abroad has reduced. These two factors are making us less bearish on the EUR in the shorter term.”