Scope for consolidation in EUR/USD rate
The almost uninterrupted appreciation of the euro relative to the US dollar since the end of May is likely due to two key reasons. The first reason has to do with the US dollar. The broad decline in US rates has weighed heavily on the greenback. In particular, the sharp decline in the US 10-year real rate has almost brought it down to German levels, something not seen since 2013. The second reason is the bold EU recovery fund deal hammered out in July, which has reduced concerns about the debt sustainability of the more vulnerable European countries.
But while the potential for either of these factors to contribute more to euro strength now appears rather limited, at least in the next few quarters, we see two other drivers that could support further appreciation of the single currency relative to the greenback further out.
First, despite the recent weakness of the US dollar, it remains significantly overvalued. In particular, the misalignment of the inflation-adjusted US dollar trade-weighted index relative to its long-term average has reached levels that historically have favoured mean reversion. Second, we see scope for the US economy to lag the global economic recovery.
In the medium term, a growth differential that less favourable to the US relative to the euro area and the overvaluation of the US dollar should pave the way for a further rise in the EUR/USD rate. Our 12-month forecast now stands at USD1.25 per euro.
However, in the short term, we see limited scope for the euro to climb from its current level against the US dollar. The euro’s strong rise since May and the recent weak inflation data in the euro area may mean the European Central Bank hints at further policy stimulus at its meeting on 10 September. Furthermore, the deterioration of the health situation in the euro area may weigh on the short-term growth outlook. In addition, Brexit uncertainties are likely to increase as the deadline to find an agreement on the EU’s future trade relationship with the UK is approaching fast. Our 3-month projection is thus USD1.17 per euro.
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