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Bullish euro/bearish dollar trend to continue?

EURO/DOLLAR COMMENT

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:

DOLLAR-NEGATIVE:

  • Criticism of the way President Trump has conducted himself and led the US so far has not helped global perceptions of the US and hence the dollar, and this could worsen.
  • Trump’s difficulties in Washington (many of his own making), including with health care, plus the Russia-related investigations have slowed down the policy rollout, and this may not recover
  • ‘Normalization’ of US rates (i.e. increasing them towards where they might be in a more normal cycle, a percent or so above inflation) could be delayed as the PCE inflation measure – whether ‘core’ or headline - has not yet firmed towards the Fed’s 2% target. The last data for core PCE inflation was a year-on-year rate of 1.4% in July, down from 1.5% the previous month.
  • The Bloomberg-based analysis of Fed funds futures suggests only a 32.8% probability of a rate hike in December; if that sentiment continues to hold, it would continue to be dollar-bearish.
  • There remains concern about a possible US government shutdown in October, should Congress not agree to raise the debt ceiling and approve a new budget in time; this could be exacerbated by factors such as: tropical storm Harvey-related aid and rebuilding costs, extra defence expenditures if the overall geo-political situation worsens (especially with North Korea), together with the arguments once again heating-up about the funding of Trump’s ‘Wall’.
  • The US goods trade deficit increased by 1.7%, to $65.1 billion in July; exports fell 1.3%, affected by a 8.0% fall in motor vehicle shipments, and a fall in exports of capital goods, while imports fell 0.3%, reflecting a 2.8% fall in motor vehicle imports, as well as a 1.7% fall in industrial supplies. On the other hand, Europe as a whole enjoys a sizable trade surplus.
 
DOLLAR-POSITIVE:
  • In the words of Warren Buffet, the US has the ‘secret sauce’ to run a capitalist economy (vs. the Eurozone being a socialistic mixture).
  • We use the analogy of the return on equity of the S&P500 index vs. that on the Euro STOXX 600 as a relative investment indicator for our purposes. Bloomberg estimates the ROEs for 2018 to be 17.05% for the S&P500, and 9.46% for the STOXX Europe 600.
  • Given the relentless tide of bad news (now including concern about the US debt ceiling), any good news whatsoever could rally the dollar, perhaps by 2-4%.‎
  • We believe there is very little in the current S&P500 earnings estimate for 2018 for positive Trump-related stimulatory factors. However, if the markets begin to view this more optimistically (tax reform getting through Congress, even if watered-down, or more infrastructure spending, with less red tape for business), then the dollar could rally.
  • US economic data - looking beyond the weak August payrolls - remains quite good, and is now coming off an upwardly-revised second quarter GDP growth number (a 3% annualized rate, up from 2.6%), and this is supported by an improving trend in the Citi US Economic Surprise Index, which has recovered from a reading of -79 at the end of June, to -18 currently. 
  • The effects of tropical storm Harvey will cause upcoming economic data to be slightly softer in the US, but the markets expect this - and what will have to be a considerable rebuilding effort should be supportive of economic forecasts after the initial hit.
DOLLAR-NEGATIVE: 
 
  • The Eurozone has lots of well-known structural problems: including inflexible labour markets, high youth (and other) unemployment, a weak Italian banking sector, and a relatively poor periphery, any of which could continue to be a drag on the Eurozone – and if there is a lack of overall progress in the above the euro could be held back vs. its peers. This is set against the background problems of gluing together so many dissimilar parts in the first place, leading to sovereignty issues, and trying to operate one monetary policy and currency for the whole bloc.
  • Negotiations with the UK regarding Brexit are making little headway, and a bad end-result could adversely affect the Eurozone, and hence the single currency. In addition, although lately off the front pages, problems with immigration and growing nationalism haven’t gone away, and these divisive issues will feature in the months to come in the various elections to be held. 
  • Campaigning is underway in the Federal elections in Germany. If Angela Merkel wins only narrowly (despite the clear recovery in her popularity), this would undoubtedly be a negative for the euro. There is also an Italian general election that must take place before May, 2018. Meanwhile, since the election of Mr Macron and his new party was deemed to be bullish for the EU and the euro, we should note that his approval rating has slumped from 64%, to about 40% now, with the French trade unions set to strongly oppose his proposed labour reforms.
  • In his comments in the Q&A session after his speech at Jackson Hole, Mario Draghi said, "…the labour market factors and…low productivity are not going to disappear anytime soon", and that, "…a significant degree of monetary accommodation is still warranted" - so although he didn’t directly talk the euro down, he did so indirectly. We believe a ‘dovish taper’ (like the ECB’s previous reduction in monthly bond purchases, but pushing the termination date out further) looks likely to come out of this week’s ECB policy meeting. Quite apart from whatever the detail is, there is a central bank-led ‘low interest rate mentality’ in Europe, which is almost totally absent in the US, and this will likely hold the euro down in the months (and possibly years) to come - of course notwithstanding an American political, or geo-political, disaster.
  • Lastly, the strength in the euro seen so far this year will now be beginning to impact export growth, paradoxically serving to limit the euro’s upside potential in the weeks ahead. Equity analysts and economists have begun to factor this into their forecasts, with some equity investors reducing exposure because of it.
EURO-POSITIVE:
  • Although President Macron probably faces an uphill battle on the streets in the short-term as he attempts to bring in labour market reforms, it is still encouraging to see such a significant historic problem being tackled head-on.
  • The Eurozone is now seeing good cyclical economic improvement, starting from the position of a good trade surplus, with Germany in the vanguard. The IMF revised its GDP growth forecasts for the Eurozone upwards in July, by 0.2% for the current year, and by 0.1% for 2018, to 1.9% and 1.7% respectively, after some years of very low growth. Looking at how recent forecasts have been coming in relative to expectations, the Citi Eurozone Economic Surprises Index has improved from +4 in late June, to just below +28. The index has been above zero since the beginning of the fourth quarter of last year.
  • Furthermore, recent officially estimated second quarter GDP growth in Germany, France, Italy and Spain has annualized at 1.7%, but in the other Euro Area countries it has been growing at 2.1%, so a broadening-out now appears to be in progress.
  • It is worth mentioning Greece’s recent successful sovereign bond issuance, the portents of which could be good for the relatively poor periphery of the bloc, and after a period when the ECB seemed to be coming up against physical limits of available bonds to be able to buy for its QE.
  • The technical analysis below shows a bullish medium-term outlook for the currency pair. Looking at the divergence between spot (at $1.1912) and the medium-term moving average, the pair is still a bit overbought, however the major technical trend in the euro (as defined by the 377-day MA) is upwards. To the upside, little overhead resistance is evident until $1.2400-1.2500. To the downside, the pair could quite easily test $1.1200-1.1400, and this would be consistent with any bounce in the dollar index.
05-09-2017

CONCLUSIONS:
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 *).

APPENDIX:
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.

For any inquiries related to this article, please contact Alain.Marckus@nbad.com or Clint.Dove@nbad.com

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