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#Market Strategy — 27.07.2017

Outlook Change For The Euro/Dollar

Guy Ertz

  • Dollar weakness has continued in recent weeks. Doubts over the ability of the Trump administration to deliver regulatory and tax measures have intensified, thus reducing inflation expectations again.
  • Weaker-than-expected inflation data and the absence of wage pressure in spite of the low unemployment rate suggest that the Fed is facing growing pressure to delay rate hikes further.
  • We have decided to adjust our outlook for the Fed. We no longer expect the next interest rate hike to take place in December but rather in March 2018. This means no more rate hikes this year and 3 hikes in 2018. In other words, one rate hike less than previously expected.
  • In the short term, we see few key triggers for a strengthening of the dollar on the political and fundamentals side. The overbought indicators and the large long position (speculative positions betting on a rise in the currency) on the euro, however, suggests a normalisation in the short term.
  • Despite our change in view about the Fed, we think that the markets are underestimating what the Fed will do in terms of policy normalisation while the opposite is true for the ECB outlook. This supports the view that the dollar is making a gradual come-back.
  • We have revised our 3-month target to 1.13 based on technical and momentum indicators. Our change in outlook for the Fed’s rate policy also led us to change our 12-month target to 1.10 (vs. 1.05).


Rising Political Uncertainty Should Lead The Fed To Hike Only Next Year

Doubts regarding the ability of the Trump administration to deliver regulatory and tax measures have intensified in recent weeks. The US President is facing major hurdles to repeal the Affordable Care Act (Obamacare) which will limit his room for manoeuvre for implementing other stimulus measures in the short term. The investigation into Trump’s ties with Russia is also weighing on market confidence and on the ability to find broad political support.

In view of the lack of improvement on the political front and the absence of drivers for inflation over the next few months, we have changed our outlook on the Fed. We no longer expect the next interest rate hike in December but rather in March 2018. This means no rate hike this year and 3 hikes in 2018. In other words, one rate hike less than previously expected.  We expect the Fed to announce a reduction in the balance sheet in September. The ECB is expected to reduce its QE programme very gradually. Inflation is picking up but only very slowly and the recent strong appreciation of the euro is already a form of tightening which will curb inflation. A smaller interest rate differential between the US and Europe is somewhat limiting the upside potential of the dollar compared to our previous scenario.   

We expect gradual upside for the dollar from current levels as the markets are underestimating the Fed’s rate hike potential and the Republican Party’s ability to implement regulatory and tax measures. The US mid-term elections in November 2018 will act as a key incentive for finding a compromise in order to ensure that there are material signs of an economic improvement by spring next year.
 

Triggers For A Dollar Comeback And Concluding Remarks

In the short term, we see few triggers for a dollar strengthening on the political and fundamentals side.

Once again, the euro reached overbought levels against the dollar a few days ago based on the Relative Strength Index (see chart Another indicator of excess is that he market has built a large “short” position (speculative positions betting on a fall in the currency) on the USD and a large long position (speculative positions betting on a rise in the currency) on the euro.  This suggests some dollar strength ahead.

In terms of technical analysis, a correction is expected and the 50-day moving average will be the next key support level at approximately 1.13 (value of 1 euro). We cannot rule out further euro strength in the short term (1.177 is the next resistance).

In the medium-term, we expect some dollar upside as the markets are underestimating the Fed and the likelihood of regulatory and tax measures being implemented later in the year.

We have revised up our 3-month target to 1.13 (value of 1 euro) based on technical and momentum indicators. Our change in outlook regarding the Fed’s interest rate policy led us to change our 12-month target to 1.10 (instead of 1.05).