CurrenciesEURUSD: Between politics and central banks

CIO continues to forecast EURUSD at 1.18 in three and six months, and 1.20 in 12 months. Allowing for some fluctuation, a trading range of 1.15 to 1.20 appears realistic. US tax plans and ECB policy have the potential to surprise.

CIO thinks a EURUSD breakout from the 1.15 to 1.20 trading range is unlikely to be sustainable. (Keystone)

Is US tax reform coming, and if so, to what extent? What will become of the budget proposal for 2017/18? Such questions are on CIO's radar at present. "For EURUSD, the main uncertainty is, in our view, the success of the US administration in implementing the new budget proposal and tax reforms," explains CIO strategist Thomas Flury. CIO qualifies US Federal Reserve (Fed) policy as a second-tier risk, given that the Fed will optimize its rate hike path based on the fiscal impulses stemming from the tax and budget decisions.

One potential scenario is that the US administration could surprise markets by giving the economy a significant fiscal impulse (for example, by cutting corporate or personal income taxes, or finding new investment programs), which would support the US dollar directly or indirectly, via a steeper Fed rate hike path. Alternatively, these impulses might not emerge, which would likely lead to a continuation of the current dollar weakness, or even a further decline.

Alongside this is the influence of the European Central Bank's (ECB) monetary policy, and the pace of its planned normalization. This depends on several factors, such as global growth, political stability in Germany, Italy and Spain or the Brexit negotiations. A key milestone on the way to Eurozone economic recovery would be the ECB defining the end of asset purchases, which would give the euro significant momentum.

CIO anticipates an October or December announcement regarding a reduction of asset purchases, but the end of the quantitative easing (QE) program could remain undefined. At the same time, the Fed is moving at a moderate pace along its rate hike path. "In this constellation, EURUSD is likely stay in the 1.15 to 1.20 range, and therefore be confined within our three- to six-month forecast," says Flury.

Are surprises possible? The strategist believes so; for example, if the ECB were to define the end of QE and/or discuss rate hikes. In that event, EURUSD could rise further towards purchasing power parity (which CIO estimates at 1.27). On the other hand, a positive surprise in the US budget negotiations coupled with a more hawkish Fed response could put EURUSD under downward pressure, provided the ECB remains vague about a potential end-date for QE. In that case, current EURUSD support levels of 1.12 could be tested.

Meanwhile, a combination of positive surprises on the US political front and from the ECB could lead the forces of appreciation and depreciation to cancel each other out. In any event, Flury doesn't think a EURUSD breakout from the 1.15 to 1.20 range is likely to be sustainable.