EUR/USD may extend gains - ANZ

The current discouraging blend of political uncertainty and receding interest rate expectations in the US have contributed to the dollar’s sell-off and the euro area’s financial conditions remain very accommodative, suggesting the recent rise in the euro won’t choke the recovery, according to Brian Martin, Head of Global Economics at ANZ.

Key Quotes

“Having moved in a broad 1.05-1.15 trading range for the best part of the past two and a half years, EUR/USD is currently breaking to the topside. There are numerous justifications for this amongst which are obvious candidates like the receding deflationary risks in the euro area, the ECB’s updated forward guidance (consistent with the improving euro area expansion), the more sober assessment of Trump’s policy agenda, the current weakness in US inflation and the anticipated short-term pause in US rate normalisation.”

“Now that a move towards the top end of the established trading range around 1.15 has been achieved, the question now is if a more sustained and durable trend in EUR/USD is emerging or whether EUR/USD is moving into a higher trading range.”

“Current monetary conditions are very accommodative, supported by loose money market conditions, low bond yields and robust equity markets. And whilst the EUR/USD has appreciated recently, it remains below the long run average since the euro’s inception in 1999 (1.21). In addition, the current strength of euro area growth and high current account surplus (3.4% of GDP) does not warrant the degree of euro undervaluation vs USD that has prevailed until recently, especially against a backdrop where the end of QE is approaching. That has been reinforced by the ECB’s upgraded forward guidance and has been reflected in both the yield curve and the euro.”

“Although the exchange rate may not be a policy tool, this doesn’t mean that the ECB will tolerate a sustained appreciation in the exchange rate back towards 1.40 which is where it was before it began its cyclical depreciation in earnest. A too strong an exchange rate could undermine the fragile stabilisation/improvement in inflation whilst tighter monetary conditions could restrain the recovery’s dynamism which is needed to close the output gap and put upward pressure on underlying inflation.”

“Further gains in EUR/USD look plausible, although there are likely to be limits to the ECB’s tolerance for a stronger euro.”