EUR/USD Rate Seen Running to 1.20 Over Coming Days but, for 2018, the Bears are at the Gates

Higher inflation and a "grand coalition" in Germany could push EUR/USD above 1.20 near-term, but relative interest rates and tax reforms have bears gathering at the gates. 

The Euro-to-Dollar exchange rate could fall sharply by the end of 2018 as the search for yield dominates while, in the short term, inflation figures from both sides of the Atlantic will determine if the common currency can push higher during the week ahead.

EUR/USD is en route to 1.20 over coming days argue a number of strategists with Thursday’s PCE inflation numbers from the US tipped to feed fears recently expressed by Federal Reserve officials over the low level of US price pressures.

Lower-than-forecast inflation readings tend to weigh on a currency, so disappointment out of the US could hurt the Dollar and allow EUR/USD higher.

PCE data covers the October month and is set for release at 13:30 Thursday and analysts are forecasting a rading of 1.4% in annualised terms. The data comes against a backdrop of Eurozone price data which, given surprise falls in the previous month, are expected to show an uplift in both the headline and the core measures of inflation without too much trouble.

“Consensus is looking for a slight uptick in both the headline and core readings; while the latter may only nudge up to 1% year-on-year, this could be marginally supportive for the EUR - given that EZ markets are relatively under-pricing inflation,” says Chris Turner, head of foreign exchange strategy at ING Group. “EUR/USD could make a run at 1.2000/20.”

The net effect of the week's data could be a short-term narrative of inflation divergence which, apart from boosting the Euro at the expense of the Dollar, is notable for both US and Euro currencies as central banks on either side of the Atlantic are attempting to stoke inflation with extraordinary monetary policies.

“EUR/USD has broken back out of its mini-range and while it did so in holidaythinned markets, the odds are that we’ll see 1.21 again this side of Christmas,” says Kit Juckes, chief foreign exchange strategist at Societe Generale.

Above: Euro-to-Dollar shown at daily intervals.

2018 interest rate rises from the Federal Reserve are seen as being hinged upon a gradual improvement in underlying inflation pressures. Likewise, the withdrawal of European Central Bank QE (bond buying). Developments around both will be key for EUR/USD during the months ahead. 

“Positioning charts suggest a certain wariness would be in order and relative yields (ones) provide ample to reason to doubt the break,” adds Juckes. “I’ll feel really stupid if this is a great big head-fake, but I think the gravitational pull of all those PPP/FEER valuations is too strong to resist.”

Nonetheless, in the short as well as medium term, relative differences in transatlantic interest rates could pose as a powerful anchor for EUR/USD.

“Germany seems to be edging ever-so-slowly towards resolution of its political impasse, which is more than can be said of the UK or the US,” says Juckes. “Angela Merkel and Martin Schulz will start negotiations on Thursday and concern about the alternatives is likely to help them reach some kind of agreement.”

Another important factor for EUR/USD is the outcome of the latest round of talks to form a coalition government in Germany, this time between former grand coalition partners the CSU and SPD.

Both are expected to renew their old coalition in order to stave off the spectre of a minority government or renewed elections. The conclusion of talks might be a pivotal moment for EUR/USD heading into year end.

Euro Could Head Sharply Lower in 2018

“Funding currency status in itself may not be reason enough to be bearish EUR, but it further supports our moderately negative stance and raises the hurdle for positives that drive the bullish consensus playing out,” says Elsa Lignos, head of foreign exchange strategy at RBC Capital Markets.

Above: Euro-to-Dollar rate shown at weekly intervals.

Beyond the very short term, opinions on the trajectory of the Euro-to-Dollar rate are divided.

The majority of strategists say a mismatch between current pricing and “fundamental values” should drive the Euro higher against the greenback during the year ahead, potentially above the 1.2500 threshold. But a handful see other forces keeping a hard cap on the common currency.

“Selective FX carry trades are starting to make sense again as the yield on conventional assets sinks to ever lower levels,” Lignos writes, in a recent note. “Rising sensitivity to outright yield may go a long way in explaining why AUD has been so robust to a negative interest rate dynamic in 2016.”

RBC Capital Markets forecast EUR/USD to fall to 1.1200 by the end of the first quarter 2018, before dropping to 1.0800 during the third quarter and, eventually, returning to 1.1200 by the end of 2018.

EUR/USD was quoted at 1.1929 during early trading in London Monday, up 0.01% on the session.

“Perhaps surprisingly, and despite significantly negative yields, EUR does not feature as a good funding currency,” says Lignos, in a recent note. “This may change if EUR continues to shed the status of safe haven that it had until recently and starts to trade as a risky asset again.”

While the common currency’s safe haven qualities mean it might be exempt from the stigma of “carry currency”, ultra low interest rates are expected to remain a factor in Europe for some time to come, while rates in the US continue to rise.

This lends support to RBC’s forecasts and might help to keep a cap on the EUR/USD rate during the year ahead. Others cite the prospect of US tax reforms passing through Congress and being enacted during early 2018 as grounds for EUR/USD bearishness.

Pound Sterling Live reported earlier in November how Bank of America Merrill Lynch, which has been voted Institutional Investor’s "Top Global Research Firm" for six consecutive years, is betting the EUR/USD rate falls to 1.10 in the first quarter of 2018.

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