Economics, not politics, should send the euro higher

Thought of the day

by Chief Investment Office 22 Jan 2018

The pendulum of political risk has swung away from Europe and toward the US. While the US government is heading for its third day of shutdown, Germany finally seems to be making progress toward forming a coalition. The fact that this failed to boost the euro versus the US dollar could be taken as a sign that the European currency has hit a wall – having been the best performing G10 currency over the past 12 months with a rise of 14%. There are signs of over-extended investor positioning, with net long positions the highest they've been since the euro was created in 1999.

But we see economic reasons why the euro can climb further over the coming three months:

  • The most recent European Central Bank (ECB) minutes suggest a growing consensus to end QE this year. While the recent rise in EURUSD may lead to dovish ECB communication this week, the Eurozone’s continued economic strength and the resulting desire to tighten forward guidance (on 8 March, by our estimates) should continue to support the euro. In contrast we see the Federal Reserve maintaining its current pace of stimulus removal.
  • Relative current account dynamics favor the euro. The Eurozone is running a current account surplus of roughly 4% of GDP, compared with a US deficit of roughly 2%.
    The EUR remains undervalued versus the USD. We estimate fair value of 1.28 on a purchasing power parity basis.

So we expect EURUSD to appreciate modestly from its current 1.225. Our three-month forecast is 1.25.

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