EUR/USD Rate Forecast: Morgan Stanley Decline Invitation to the Parity Party

EUR/USD decline to end before parity argues one of the world's largest investment banks.

Suddenly those analysts who have been projecting the EUR/USD to fall to a 1:1 exchange rate aren't looking like the outliers in the forecasting community that they once were.

Momentum has turned decisively against the shared currency of late and forced analysts to reconsider their expectations on where the bottom lies.

The Euro has suffered as global FX market switch theme to one where yields on government bonds are the primary concern.

This theme was forced upon foreign exchange markets by the ascendance of Donald Trump to the US presidency and the realisation that we faced a future of increased spending and potentially higher inflation.

This forced the price of government bonds lower and their yields higher and has the prospect of the EUR/USD reaching parity as one of the most popular topic of conversation in the world of FX at present.

“The Euro appears to be suffering from the continued focus on austerity and the reining in of debt levels across the currency bloc. This policy is now in stark contrast with the fiscal largesse in the US and the UK, which is a key driver of higher Treasury and Gilt yields,” says Kathleen Brooks at City Index.

As the spread between German 10-year and US 10-year yields has fallen to more than -2%, the Euro-Dollar exchange rate has dropped in lock-step.

Brooks notes the correlation between the euro and German 10-year bond yields has surged to nearly 80% in recent days.

However, Brooks questions whether the EUR/USD will fall all the way to parity:

“If you want to see whether EURUSD will reach parity, then watch the German – US yield spread.

“The German–US yield spread is already at a multi-decade low, which makes us nervous about how much further it has to fall

“Over the long term the correlation between EUR/USD and the yield spread is not significant, which suggests that this period could be short lived.”

Morgan Stanley Decline Invitation to the Parity Party

Also drawing question marks over whether the Euro’s weakness can be sustained are Morgan Stanley who believe the sell-off won’t quote reach that magic 1:1 marker.

“EURUSD is largely driven by the USD leg, which means the pair could slowly grind lower towards 1.04 by year end,” say Morgan Stanley in a recent strategy briefing to clients.

Morgan Stanley think EUR should remain strong on the crosses as Eurozone banks are not increasing foreign lending enough to compensate for the current account surplus, and the higher global inflation environment reduces the need for the ECB to add to QE purchases indefinitely.

“Should the French election political risks subside, EUR could have further upside,” say Morgan Stanley.

Other names not anticipating such a steep decline include Germany’s Commerzbank whose views we have covered here.

Structurally Bullish on USD

The US Dollar is meanwhile anticipated by many to extend its 2016 run higher.

The election results reinforce Morgan Stanley’s structural USD bullish view.

“Three major policy initiatives (fiscal stimulus, trade, corporate tax reform) are likely to be USD positive and the markets focus on reflation should push USD higher against the low yielders,” say analysts.

Morgan Stanley expect the Fed to remain on track and we may see a more balanced mix of monetary and fiscal policy, lessening the need for more easing.

Data continues to come in strong and Fed commentary suggests that it is willing to put up with a stronger USD if it’s due to an improving economic outlook (as opposed to earlier in the year).

Time for a US Dollar Correction

The Dollar can't keep climbing indefinitely - this we know. The trick is calling the top.

With this in mind consider the following observations made by Steve Jarvis, chief technical analyst for TraderMade, the FX charting, data and technical analysis provider.

Jarvis has looked at USD behavior two months before and after every election since 1988.

He notes:

"The US Dollar is now in an uptrend against all other major currencies. However, it is overbought and starting to look at risk of a setback to partially unwind it's recent advance, before possibly being set to head higher still towards year-end.

"On 5 out of 7 past elections since 1988, the US Dollar formed a key turning point around 2-3 weeks after the US election (approximately the time frame we are in now). On the other 2 occasions it underwent a short-lived corrective phase, before extending its post-Election trend.

"This year's price action is uncannily similar to those of 2000 and 2008. The major differences are that after the 2000 and 2008 elections, USD did not break pre-election highs, going on to form a top pattern which lead to significant reversal pattern being completed, triggering a bearish phase for the US Dollar."