Euro-to-Dollar Rate Seen Straitjacketed by Italy this Summer but Better Days are Ahead Later in 2018

- EUR/USD will be restrained this summer by political risks in Italy.
- But can rise in second half of 2018 as ECB ends QE programme.
- Although forecasts suggest upside is more limited than before.

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The Euro-to-Dollar rate will be strait-jacketed this summer months due to lingering unease over the new Italian government's economic agenda, according to multiple strategists, but it can recover nicely later in 2018 once Italy's draft 2019 budget has been agreed with Brussels and the European Central Bank ends its quantitative easing programme.

Europe's single currency has stabilised in recent days following weeks of heavy losses, brought about by a resurgent US Dollar and fears over the new Italian government's commitment to the Euro, which pushed EUR/USD to a near-year-long low of 1.1515 at the end of May.

This downward move prompted J.P. Morgan strategists to lower their forecasts for the Euro-to-Dollar rate last week although, and while the currency is not quite out of the woods just yet, buyers of the exchange rate need not give up hope of better rates to come later in 2018.

"For now we hold to the core assumption that Italy avoids a systemically de-stabilising bad outcome," says Paul Meggyesi, vice president of global currencies and commodities at J.P. Morgan. "A populist government which is noisy but which nevertheless eschews EMU exit will delay and limit EUR appreciation but not preclude it entirely."

Meggyesi and the J.P. Morgan team say that Italy is likely to avoid a Greek style confrontation with the European Union, in which an exit from the Eurozone could potentially be placed on the table. Nonethless, they have still downgraded their year-end forecast for EUR/USD by five whole cents, from 1.25 to 1.20, which isn't a long way off the 1.1775 level seen on Wednesday.

"The new forecasts are provisional rather than definitive, and subject to further revisions should visibility improve around Italy," the strategist writes, in a recent briefing.

The forecast for a rise to 1.20, however, is conditional on the Eurozone economy recovering from the first-quarter lull that pushed GDP growth down from 0.7% at the end of 2017 to 0.4% for the first-quarter of 2018.

It is also hinged on the assumption that the European Central Bank bites the proverbial bullet and finally winds down the quantitative easing programme that has seen it hoovering up tens of billions of European bonds each month ever since early 2015. Markets are looking for the ECB to signal an end to the QE programme in its latest monetary policy statement, due this Thursday.

Analysts at Credit Suisse are a little more bullish in their outlook for the single currency, although they still see it remaining range-bound during the summer months before eventually recovering toward the end of the year. Their bullish stance is also based on the belief the ECB will soon wind down its stimulus programme.

"We think that it (an end to stimulus) will start playing through in December and will have a profound impact on market pricing right now. It is all a reflection of the Euro-dollar cross. We think the Euro has further to appreciate and the Dollar further to fall," says John Woods chief investment officer at Credit Suisse.

Woods says Thursday's ECB meeting offers the central bank an opportunity to set out a path toward ending QE and that markets will begin to price in an actual end to the programme as soon as this week. He also predicts a rebound in Eurozone economic growth later this year, which could help the market become more confident about betting on an eventual interest rate rise on the continent.

"We think growth will re-accelerate in the third and fourth quarters and on that basis we will see a re-pricing of interest rate expectations - more so than we are now," Wood says.

However, a lot of what happens to the Euro in the months ahead will depend on the market reaction to the Italian government's first draft budget, which is due to be submitted for approval by the European Commission in October.

"If they do take a populist stance then we could see a resumption of Dollar strength with a hit for the Euro; if they don't then upside for the Euro," says Shahab Jalinoos, global head of FX strategy at Credit Suisse, in a recent interview with Bloomberg News.

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