EUR/USD: Turbulence Ahead as Dollar Reigns Supreme but Bullishness in order for 2018

Tax cuts and a debt-ceiling-debacle are lifting US yields and pressuring EUR/USD. This could continue into New Year but strategists are still bullish in their 2018 targets.

The Euro to Dollar rate could have a rocky ride into year-end and the early stages of 2018 as the greenback gets a lift from expectations around the Trump administration’s tax cuts and Euro strength moderates for the time being.

Evolving expectations for Federal Reserve rate hikes are also key to expectations for the Euro-to-Dollar rate over the months ahead, with some economists suggesting the US central bank will become more hawkish over the coming weeks and months.

“There’s enough chatter about the 2-year yield differential to make me wonder if we will finally flush out stale long Euro positions and shake a bullish EUR/USD consensus,” says Kit Juckes, chief foreign exchange strategist at Societe Generale.

Gaps between bond yields are key drivers of currency prices as, for instance, yields on US bonds that are higher and rising more than those of Euro bonds can prompt investors to sell the Euro currency and buy Dollars in order to exploit the higher return available across the pond.

“The widening in the US/Euro 2 year yield spread has accelerated, and is closing in on 1997 highs. This is giving encouragement to dollar bulls (and to euro bears) and has dragged EUR/USD through the bottom of its micro-range,” notes Juckes.

Above: EUR/USD shown at hourly intervals. Captures Euro weakness and Dollar strength in December.

Rising yields are being driven by multiple factors. Expectations the Trump administration will be succesful in getting its tax-reform bill through Washington are the most notable.

This will cut the US corporate tax rate by close to 40%, down to a little more than 20%, while reforms to personal taxes will also put more money in the pockets of American families.

The net effect of the tax bill is likely to be faster economic growth and an additional boost to US inflation which, in turn, may mean the Federal Reserve has to raise its interest rate faster than the market currently gives credit for. That would bring even higher US yields, a stronger Dollar and a lower EUR/USD rate.

“The US Fed is on track to raise rates next week and then four times in 2018, as core inflation picks up gradually. In contrast, only one hike is priced in by financial markets for next year,” says Paul Ashworth, chief North American economist at Capital Economics.

In addition, concerns over a possible government shutdown at the weekend, read more about that here, may also be helping to lift short term US bond yields and further compounding pressure on the Euro-to-Dollar rate.

The end result of all this for EUR/USD could be that the rate struggles to gain ground until some time after the US tax reforms have been passed and implemented. 

The Euro currency may also need to get over a possible bump in the road around the Italian election that is expected to take place some time in the first quarter of 2018, before it is able to recover lost ground from the greenback.

Above: EUR/USD shown at weekly intervals. Captures longer term peaks and troughs in exchange rate.

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Short-term and 2018 Targets

In fact, may expect EUR/USD will fall until the end of the first quarter 2018, with strategists only diverging over how far it falls over the coming months.

Strategists at Bank of America Merrill Lynch say the EUR/USD rate could drop as low as 1.10, down from 1.1780 on Thursday, 7 December, before the first three months of 2018 are out of the way.

“We see potential for better growth, higher rates, and a near-term stronger USD as a result, especially as tax cuts could be front-loaded in light of the upcoming 2018 mid-term elections,” writes John Sin, a strategist at Bank of America Merrill Lynch, in a November note.

The team at Svenska Handelsbanken are calling the rate at 1.1500 by the end of Q1 2018, which still implies a substantial fall, before it bounces back to around the 1.2000 level in time for year-end. This is an upgrade to their earlier forecast.

“All in all, we still see some scope for an appreciation of the USD vs. the EUR but expect a milder move than our previous forecast,” writes Lars Henriksson, a strategist at Handelsbanken, in a note Thursday.

RBC Capital Markets say the Euro-to-Dollar pair will go down to 1.12 in the first quarter, before dropping to 1.08 around the middle of the year and returning to 1.12 for year end.

That said, in the same way that many strategists are bearish on EUR/USD in the short term, most are also quite bullish in their outlook for the pair at year-end.

“The Euro has changed and we should embrace it. It is no longer priced as a tail risk currency. With ECB policy normalisation at its start, there is plenty of upside,” says Petr Krpata, an analyst with ING Group, writing in the bank’s 2018 foreign exchange outlook.

Krpata and the ING team forecast the Euro will rise to 1.30 against the Dollar before end 2018, while the Credit Agricole team put it at 1.2500. Juckes at Societe Generale predicts the EUR/USD pair will rise to 1.27 by 2018 year-end.

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