EUR/USD To Dip N/T; Buy The Dip For A Continued Rebound In H2
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Arguments for a 1-3M dip in EUR/USD... A key argument for a EUR/USD dip near term is the potential for a temporary revival of relative rates, not least due to the fact that positioning is much closer to neutral. Also, a cyclical situation set to evolve in favour of the US in coming months and the risk of a ‘Brexit’ also suggests to us that the cross could be vulnerable on a 3M horizon. Return of relative rates as an FX-market driver At the start of the year we argued that despite the Fed having initiated a hiking cycle, we saw limited potential for tighter US monetary policy to send EUR/USD lower due to very stretched short EUR/USD positioning; the reasoning being that when investors are already positioned in one direction, the arguments (e.g. moves in relative rates) to add to this position most be increasingly strong
While EUR/USD has indeed edged higher since the New Year, we are now in a situation where positioning is much closer to neutral for the cross overall. At the same time, the pair has, in our view, gone a little too far considering recent moves in not least relative rates, both judged against moves in a 2Y swap and 10Y government-bond spread perspective.
In addition, our rate strategists look for US short-end yields to move higher ahead of September, when we expect the next Fed hike to be delivered. Currently, the market is pricing a mere 60% probability of this and thus we expect to see US money-market rates edge higher in coming months as it becomes clear that the Fed is ready to continue its tightening cycle. That said, a move in relative rates should come primarily from the US leg as we look for EU rates to evolve broadly in line with market pricing near term: notably we see limited potential for more downside to the short end of the EUR curve as almost another 10bp cut from the ECB is priced by January 2017, which seems fair given that we think the ECB will stay away from the quick fix of using the rate/currency channel aggressively to foster inflation and prefer QE for now
On the whole, we thus see EUR/USD giving in on the downside to impulses from relative rates moving in favour of USD on a 1-3M horizon as positioning leaves room for this factor to play a role again for a while. Cyclical situation favouring US in 3M US data surprises have turned negative lately while the opposite has been the case for the euro area, but our quantitative cyclical model, MacroScope, suggests that the US cycle will improve on a 3-6M horizon, whereas the opposite could be the case for the euro area. This should make the Fed more confident in continuing the hiking cycle and thereby strengthen the case for USD tailwinds in the short term.
On a 6-12M horizon, the macro picture is set to be less USD-supportive as a significant pick-up in euro-zone inflation looms.
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