BofA Sees EUR/USD At 1.15 Before Year Is Out, Says To Buy Dollar Dips

An onward march from the Fed, a dovish ECB and recent flow data mean the greenback goes higher and EUR-USD comes down.

Traders should buy dips in the greenback, according Bank of America Merrill Lynch, and prepare for a further fall in the Euro-to-Dollar rate as the Fed marches onward while the European Central Bank turns dovish before the year is out.

Strategists at BofA say the Federal Reserve will leave its inflation projections unchanged in its September 20 announcement, implying a rate hike in December is still a go, before continuing to normalise policy in the New Year.

"For the first time the Dot Plot has been right this year and markets have been wrong, and we believe that this remains the case. Higher inflation ahead provides even more justifications for the Fed to keep normalizing policies," says Athanasios Vamvakidis, a foreign exchange strategist at Bank of America Merrill Lynch.

September's FOMC decision will likely see the beginning of a great unwinding of the Fed balance sheet, although advance communication of this probability means markets have largely priced in already, leaving the focus on the so called dot-plot - the Fed's inflation forecasts.

Federal Reserve assets and liabilities. Purple line in left hand graph shows QE assets. Source: Yardeni Research.

"The Fed has been hiking and keeping the Dot Plot the same despite low inflation this year, focusing on loosening financial conditions instead," says Vamvakidis. "We would buy the USD dip if we get one."

With markets having almost completely discounted the prospect of another rate hike this year, amid disappointing inflation numbers and uncertainty over the future composition of the FOMC, a December hike could give the US Dollar a boost. So far, the greenback has been the worst performing currency in the G10 basket for the year to date.

Meanwhile, with currency strength eating away at the little inflation that there is in the Eurozone, the European Central Bank could begin to sound increasingly dovish before the year is out

"We forecast EURUSD at 1.15 by the end of the year....financial conditions in the Eurozone have actually tightened this year and the ECB inflation projections are optimistic, in our view," Vamvakidis wrote in a note.

The Euro saw a steep pullback in the wake of the European Central Bank's September meeting, after it briefly topped a two and a half year high close to the 1.2100 level. A further correction of the EUR/USD rate is necessary, Vamvakidis argues, because the common currency has overshot its fundamental value since June.

Not Everybody Got The Memo 

Strategists at Morgan Stanley have a different view of the greenback's likely fate during the months ahead and see further gains for the common currency over its American rival.

“There are concerns building that USD has already moved a long way and that bearish sentiment is too extreme.... We still think the USD will decline, but probably at a less rapid pace than we have seen,” says James Lord, an fx strategist at Morgan Stanley.

The Dollar shares an inverse relationship with investors' and traders' appetites for risk. And with the global economy remaining on an upward trajectory, speculators and real money investors are likely to remain comfortable with risk and to continue chasing yield. A Federal Reserve that remains committed to a gradual hiking cycle will merely reinforce this trend, according to Lord.

"We concentrate our USD shorts against EM and forecast gains for EUR and AUD too,” says Lord, who forecasts that the Euro-to-Dollar rate will reach 1.2200 before year end and rise to 1.2500 in the first quarter of 2018.

The Morgan Stanley team does, however, note that were the US economy to produce a sustained run of strong and above-consensus inflation numbers, then the Fed could start to pick up the pace a bit. This would be costly for short-sellers of the greenback as it would pull money flows back toward the US Dollar.

Source: Morgan Stanley Research Report