Global Asset Management - First Abu Dhabi Bank
Tel: +971 4 4245795
Abu Dhabi, 05 September, 2017
We have revised our expected six-month trading range to $1.1200-1.2500 (from $1.0500-1.1700 previously).
INTRODUCTION: Partly a function of dollar weakness, and also because market participants have reached the overall conclusion that the Eurozone may not be such a negative proposition after all, the euro/dollar currency pair has rallied from a low of just below $1.0400 at the end of last year, to $1.1912, after a closing high of $1.1979. We know about the Trump-related negatives, following earlier hopes that his Administration’s policy agenda would be an economic breath of fresh air. At the same time, via the election of French president, Emmanuel Macron, and his new political party, hopes for positive European reforms have grown - and Angela Merkel should remain as German Chancellor for a further term. Mario Draghi, President of the European Central Bank, will have been concerned to see such a strong rally in the euro in recent weeks, but hasn’t wanted to give traders the excuse to mark it higher. Our tracking suggests that the majority of historic leveraged euro net short positions have been closed. Much more strength in the euro would harm the ability of the EU to export, adding a cap to growth. The EU, being a major exporting bloc, naturally wants to win the competitive currency depreciation war (for exporting and favourable translation purposes) with its peers, while seeking to avoid capital outflows. On the US side of the equation, Steve Mnuchin, US Treasury Secretary, in an interview last week said he wasn’t particularly bothered about recent dollar weakness, as this helps US trade. The technically overbought condition of the euro/dollar has moderated, and could be helped by any respite in dollar weakness on its index, the DXY. The DXY, having broken below 92.60 - the technically important 2016 closing low - is attempting to regain that level (currently 92.510). So what is the balance of probability now? Will the bullish euro/bearish dollar trend continue for a while longer as the complex catalogue of factors on both sides unravel? We see the main factors as follows:
The dollar has probably already discounted much Trump-related bad news for the time being, hence could easily bounce from current levels, limiting euro upside.
President Trump and US Treasury Secretary Mnuchin last week said that detailed tax reform plans had been prepared, were currently being ‘socialized’ by Congress, and if agreed could be signed by the President before the year-end. This will have been one factor arresting the fall in the dollar. Success in the passage of tax reform could lead to a bullish phase for the dollar index.
Investors should not get too excited about short-run cyclical improvements in the Eurozone when the degree of required structural change remains substantial.
The ECB's current program of QE ends at the year- end; we expect a continuation of what has already worked for the ECB .i.e. a further ‘dovish taper’.
The Fed has talked about the imminent tapering of its balance sheet (and also how this will be a very gradual affair) so often that it is probably mainly discounted.
In the event that $1.2400-1.2500 is seen in the short-term, this would likely be driven by some further unexpected negative US/dollar-related event, such as a spike in US sovereign CDS rates in anticipation of a credit downgrade, or a serious budgetary/debt ceiling impasse.
Rather than directly talking down the euro, Draghi a few weeks ago did say that considerable monetary accommodation would continue to be necessary.
The economic growth outlook in the Eurozone has improved, cyclically, probably limiting euro downside to about $1.1200-1.1400 (up from $1.0500 in our last note).
The euro’s upside limit is likely to be held to $1.2400-1.2500, held in check by remaining structural issues and some political uncertainty (Germany, and more so Italy).
The dollar index could rebound by 4-5%, essentially because it is currently oversold, and this would be consistent with a $1.1200-1.1400 level vs. the euro.
The revised expected trading range of $1.1200-1.2500 (revised higher from 1.0500-1.1700), is consistent with our medium-term technical analysis.
Our higher assumed trading range is also consistent with the latest Barclays Capital theoretical ‘REER’ (real effective exchange rate index, adjusted for inflation and trade balances), which gives a reading of 72.38 for the euro, i.e. below 100, and therefore relatively undervalued within the currency universe (see the Appendix below *).
NOTE ON ‘REER’ (*) : Source: Investopedia – “The real effective exchange rate(REER) is a measure of the weighted average of a country’s currency against an inflation-adjusted and trade-weighted index of other currencies. The trade weighting is done by comparing a country’s trade deficits relative to its main trading partners. This comparison is made between each currency included in the index. The inflation adjustment is made by comparing the purchasing power of each currency relative to one another”.
REER is a theoretical methodology used to determine currency values, similar to Purchasing Power Parity. Our FX traders favour the Barclay’s model. A country can positively affect its REER through rapid productivity growth, for instance; when this happens, a country realizes lower costs and can reduce prices, thus boosting its REER ranking, other things remaining equal. An understanding of a country's REER is important when conducting economic analysis and policymaking. Accordingly, the World Bank, Eurostat, the Bank for International Settlements, and others publish REER indicators.
This year’s Global Investment Outlook, the third in the GIO series, is optimistic about the outlook for the prices of risk assets this year. The report draws upon the expertise of a range of investment professionals from across NBAD, and reaches conclusions about how portfolios should be positioned.
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