Don't Get Carried Away, Say Credit Suisse, EUR/USD has Limited Potential
EUR/USD has broken above the key psychological 1.10 handle and this has led many market operators to see a more substantial longer-term trend higher evolving, with some bank forecasters now seeing moves up to the late teens and even 1.20 eventually.
The balmy outlook is based on converging interest rate expectations after reports from members of the European Central Bank (ECB) governing council said that they are worried about keeping interest rates ultra-low for too long amidst a recovering panorama, as if and when they do lift them it may come as too much of shock to borrowers, who had got used to ultra-cheap debt.
One of the main drivers behind currency moves are the difference between the interest rates set by central banks in respective countries.
Currencies subject to higher interest rates tend to strengthen versus those with lower rates because international capital moves from low to high interest rate currency jurisdictions in order to benefit from the higher yield return.
The possibility Eurozone interest rates might rise is, therefore, supportive of the Euro.
The latest member to put forward the idea that the ECB needs to be open to raising interest rates was the permanent member of the ECB, Benoit Coeure, but German officials have also communicated a similar view in the past.
The ECB currently undertakes quantitative easing (QE) whereby it buys mainly sovereign debt from banks in order to keep interest rates low and to inject liquidity into the banking system.
This was an extraordinary measure brought in to deal with a crisis and that is why policy makers are coming under pressure to dismantle it.
Recent data has shown a robust recovery in the Eurozone which could lead to a risk from having interest rates too low as this could force the ECB to increase interest rates in big jumps.
These forecasts may be overly optimistic, however, according to Credit Suisse, who see upside capped by ECB monetary policy inertia.
“While we welcome recent outperformance of European data (we have been EUR bulls since late March – link), we think the scope for additional EUR upside from policy expectations alone might be limited from current levels.”
The Dollar meanwhile has had a comparatively bumpy recent history after data turned sour and now political risk is also weighing on the outlook with the Trump-Comey-Flynn scandal brewing.
Credit Suisse, however, is still quite optimistic about the probabilities of the Federal Reserve raising interest rates in June.
“The FOMC and the ECB will be holding policy decision meetings on 14 June and 8 June respectively. On the US side, OIS markets are pricing in approximately 70% likelihood of a 25bp hike at the upcoming meeting, only slightly below the peak of 78% registered before the release of last week’s inflation data. The limited nature of the move in tightening expectations suggests markets might need to see a much more convincing deterioration in US data in order to price out a June hike by the Fed,” said Credit Suisse’s Shahab Jalinoos.
Unless the ECB make a firm commitment to ending QE, US data declines substantially between now and June, or Donald Trump gets impeached – none of which look likely – the EUR/USD looks limited in its scope for further upside.
In addition, Jalinoos notes stubbornly low volatility has reached lows not seen since Q4 2014.
Research shows that there is a positive correlation between volatility and the Dollar so the fact it is at extreme oversold at the moment could indicate a bounce back higher and more upside for the Dollar eventually on the horizon, although ‘when’ is the big question.
“At the same time, average 3m implied volatility for G10 currencies continues to edge lower and is currently trading at levels previously seen in Q4 ‘14. Amid this set of steady and increasingly uninteresting market conditions, the following developments stand out as key for FX market participants,” said Jalinoos.
