Upside Risks to Euro / Dollar Forecasts on Growing Political Risk Premium in USD

Pound Sterling has been the world’s most notable ‘political currency’ since the Brexit vote of June 23, 2016, but analysts tell us the Dollar could be about to adopt a similar label, and this has notable implications for the EUR/USD exchange rate's outlook.

The political risk premium in the Pound means it trades near multi-year lows despite the country boasting the fastest growing economy in the G7.

This disconnect between economic reality and the currency’s value is described as being a political risk premium.

In short, markets are shy of exposing themselves to the Pound as they do not know how Brexit will play out.

Now, it seems a political risk premium is being absorbed by the US Dollar as the new US administration seeks to boost US exports and trigger a renaissance in the country’s manufacturing base.

This entails pursuing anti-globalisation trade policies and policies aimed at weakening the Dollar.

However, we don’t know what it is exactly Team Trump will do - but what we do know is currencies hate uncertainty.

US Dollar Weakness Ahead

The Trump administration has already put a political risk premium into the Dollar it is argued.

“A politically-driven risk premium has sneaked into USD valuations, as investors have digested the new US administration's actions and rhetoric on trade,” says Hans Redeker at Morgan Stanley.

As the below shows - the Dollar (DXY) has broken away from its traditional fundamental driver which is the interest rate market:

The gap between the Dollar and interest rate yields can be explained as they political risk premium and how big the gap grows has implications for the future of the Dollar and its main pairs.

Another political stab at the Dollar was dealt by Peter Navarro - Trump’s leading trade adviser - when he told the FT that the Euro “grossly undervalued" and suggested Germany was gaining an unfair advantage in global trade owing to its use of the Euro.

The comments, “suggest that the US administration sees the exchange rate as one of the main anchoring points for the deployment of its trade policies,” says Dr. Vasileios Gkionakis, Global Head of FX Strategy at UniCredit Research.

Gkionakis believes the comments aid a shift towards a “weak dollar policy”.

However, this policy is at odds with the imposition of tariffs, which Gkionakis points out tends to lead to exchange-rate appreciation – ignoring for the moment the possibility of retaliation.

“A stronger USD is difficult to reconcile with the creation and protection of manufacturing jobs domestically. So the market smells political inconsistency, and this is happening at a difficult point for the dollar,” says Gkionakis.

As the initial euphoria of the Trump election has just started to fade Gkionakis believes the market is only now waking up to the reality that the Trump political agenda should be associated with a risk premium.

Gkionakis believes the this political rhetoric on the Euro as being “grossly undervalued” is now acting as an additional headwind for the dollar.

UniCredit have little doubt that political high-pitched rhetoric will continue inducing volatility in the exchange-rate market.

“We think that price developments so far this year, together with investors realising that there has to be a significant risk premium priced into the USD and the recent noteworthy shift towards a “weak dollar policy” suggest that the risks for a deeper (than we initially expected) correction lower in the US currency are increasing,” says Gkionakis.

UniCredit now see increasing risks to the upside for our forecast of EUR-USD 1.10 by year-end.