Euro-to-Dollar Rate Outlook Dimmed as Multiple Storm Clouds Gather Overhead

“Our US economics team expects three hikes in 2019, and the market is priced for about one. We also see the risk of four hikes this year,” - Bank of America Merrill Lynch.

The Euro-to-Dollar exchange rate outlook has darkened in recent weeks, leaving the common currency stooped beneath multiple storm clouds that could see it come under increasing pressure during the months ahead, according to strategists at Bank of America Merrill Lynch.

Europe’s single currency has enjoyed a strong run over the last year. It has risen 2.7% in 2018 and is up by 17.2% over the last 12 months.

The European Central Bank beginning to wind down its bond buying program has been a significant factor behind the EUR/USD rise while, more recently, concerns over a rising US budget deficit have also weighed on the greenback.

However, a return of political risk threatens the currency in the very short term while, over the coming months, divergent monetary policies are expected to weigh more heavily on the Euro.

Members of Germany’s Social Democratic Party could sink the Euro next week, if they reject a proposed coalition government with Chancellor Merkel’s Christian Democratic Union.

“A recent poll indicates that 56% of SPD members would approve a coalition, which is what we are expecting,” says Hans Redeker, head of FX strategy at Morgan Stanley, in a note Friday.

“If on the other hand the SPD rejects the coalition proposal, we expect EURUSD to fall to 1.16/1.17 in which case we would be long-term buyers of EUR.”

Federal Reserve to Move Faster

Beyond March politics the auspices of relative monetary policies are expected to exert increasing influence over the Euro-to-Dollar exchange rate, with rising interest rates in America expected to pressure the Euro.

The Federal Reserve raised interest rates three times in 2017 and is expected to do the same again in 2018.

In addition, economists and strategists are increasingly questioning whether the central bank may manage a fourth interest rate rise.

“For the USD to extend meaningfully beyond near-term technical levels, though, we need to see a pickup in monetary divergence, market volatility, ex-US political risk premium or US corporate repatriation flows,” says Ben Randol, an FX strategist at Bank of America Merrill Lynch.

“Our US economics team expects three hikes in 2019, and the market is priced for about one. We also see the risk of four hikes this year.”

Federal Reserve chair Jerome Powell was perceived to have suggested four rate hikes are on the cards in 2018 when he appeared before lawmakers in Washington this week.

Among other things, he talked up the current health of the US economy and told Congress the Fed does not want to get behind the curve when it came to raising interest rates as it would risk a recession if a sudden rise in inflation forced the central bank to raise rates sharply in the future.

Current pricing in interest rate derivatives markets, which enable investors to hedge against changes in interest rates and provide insight into investors’ expectations for monetary policy, suggests three rate increases in total for 2018.

It is a change in these expectations, from three to four rate hikes, that would generate a reaction in currency markets.

US Deficit Fears to Fade Short-term

President Donald Trump’s tax reforms and other fiscal stimuli have been credited with driving mounting concerns over a rising US budget and current account deficit, which is termed as the “twin deficit”.

“Although we appreciate caution regarding long-term US budget sustainability, fiscal stimulus will have a substantially positive 1-2 year impact on US growth, as confirmed by Powell,” Randol says, countering against emerging concerns over the US deficit.

Fears are that Americans will use their saved tax contributions to sell Dollars and buy more imports, widening the trade and current account deficits.

A bigger budget deficit will also see the US borrow more from the rest of the world, further widening the current account deficit and placing additional pressure on the Dollar.

However, Randol and other strategists across the industry see these factors being outweighed as US economic growth picks up in the months and quarters ahead, forcing the Federal Reserve to raise rates faster.

“We like adding to long USD positions on pullbacks. Notably, our quant signals are aligned USD-bullish alongside our fundamental macro view,” says Ben Randol, an FX strategist at Bank of America Merrill Lynch.

Forecasts

Randol and the Bank of America Merrill Lynch team forecast the Euro-to-Dollar rate will fall to 1.15 before the end of June as the market is forced to reconsider its assumptions about US interest rates.

This fall will be aided by the fact that a European Central Bank end to quantitative easing is now take for granted by the market, in other words full priced in, and so can deliver little further upside to the Euro.

However, Randol and the BAML team also project that the EUR/USD rate will recover steadily before the curtain closes on 2018, reaching 1.20 in time for the end of December.

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