From Natixis Insights :
Since the start of the year, the EUR/USD has rebounded sharply, with a high at 1.0829 last week, recovering from a low at 1.0340. This was due mainly to the correction of the US dollar, fuelled by the first executive orders issued by President Trump, most of which have been in the way of protectionist measures, including the US withdrawal from the Trans-Pacific Partnership (TPP) and the renegotiation of the North American Free Trade Agreement (NAFTA). It seems that Donald Trump wants to rip up regional agreements in favour of bilateral agreements that will be more favourable to the US.
All these announcements have weakened the US dollar since the start of the year by driving down US long interest rates and by narrowing the spread between US and EZ interest rates. Even so, the spread between the US and EZ 2-year rates suggests that the EUR/USD’s appreciation is excessive. This has in fact been spurred by the squaring of short euro positions, with the market now just about borderline neutral on the single currency. This suggests that the EUR/USD has limited upside potential from the squaring of remaining short positions. By contrast, the pair could fall back sharply if the news flow becomes less negative for the US dollar and/or the Federal Reserve takes over behind the helm.
Recently, one of Trump’s advisers, Peter Navarro, head of the newly formed National Trade Council, said that the euro was grossly undervalued and that this was being exploited by Germany to gain an advantage over the US and its own EU partners. This came after an earlier salvo by Trump bemoaning the strength of the US dollar. All this contributed to the EUR/USD’s ascent towards 1.08. It has to be said that most benchmarks by which to measure the valuation of the EUR/USD indicate that the euro is undervalued in relation to the US dollar. The euro’s real effective exchange rate is down by one standard deviation, while purchasing power parities suggest that the EUR/USD is undervalued by more than 10%. At the same time, since 2000, purchasing power parities reveal that the pair was overvalued more of the time because of the Federal Reserve’s ultra-accommodating policy. Furthermore, the current undervaluation stems from the divergence in monetary policies in the US and Eurozone, with notably a tightening of the Fed Funds rate.
Political risks will end up weighing on the EUR/USD in the short term. First up, there are the general elections in the Netherlands, the risks attached to this event not having been priced in sufficiently considering that the PVV, the eurosceptic party led by Geert Wilders, is still in the lead in the opinion polls. As the PVV is credited with 35 seats but needs 76 for an absolute majority, it will not be able to govern without forming a coalition government, but its victory will probably be met with a frosty response by the markets, especially as there are elections shortly afterwards in France, the outcome of which are most uncertain. The bond market is starting to price in the French risk, the OAT-Bund spread having widened from 30bp before Trump’s election to 76bp this Monday after the speech by François Fillon. The market is also bringing pressure to bear on Italy, so that even though the probability of early elections has subsided, the BTP-Bund spread reaches 200bp.
Even though the US dollar is on a negative run and at Donald Trump’s mercy (since the Federal Reserve is conspicuously absent), our view is that European political risks will end up getting the better of the euro and contribute to the EUR/USD correcting toward parity come June.
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