Potential Dollar Strength, But More Limited Upside

• The euro has been benefiting from a strong momentum since the French election outcome.
• The relative economic momentum has strongly boosted the euro. We are looking for a reversal of that trend over the coming months. Furthermore, in the current context, the markets may be underestimating the Republican Party’s ability to deliver regulatory and tax measures.
• The markets are also underestimating what the Fed will do, in our view. The next meeting on 14 June will be key. We assume that the ECB is still months away from hiking the refi rate and will act very gradually when it uses other tools. A move before the German election on 24 September is unlikely.
• The euro is moving towards an overbought level against the dollar, based on the Relative Strength Index (RSI). In terms of technical analysis, a correction is expected and the 50-day moving average will be the first key support level at approximately 1.09 (value of 1 euro).
• We expect the dollar to rebound in the next few weeks/months and have a 3-month target of 1.06. Following our recent downward revision in US economic growth and upward revision in European growth, we have revised our target from 1 to 1.05.

Economic momentum and central bank expectations

Economic momentum has been strongly in favour of the euro. Indeed the economic surprise index has been falling in the US while remaining high in Europe. Similar patterns can be seen in business and consumer surveys. Such a gap is unusual, reflecting a normalisation after the initial excessive US confidence following the US presidential elections. We look for a reversal of the trend over the coming months. Furthermore, in the current context, the market may be underestimating the Republican Party’s ability to deliver regulatory and tax measures.

Market expectations regarding the Fed have been revised down in recent weeks. The markets now expect approximately 2 more hikes until the end of 2018 while we expect 5 (2 more this year and 3 next year). The markets are thus under-pricing the Fed in our view.  The central bank is considering reducing its balance sheet further via reducing its bond reinvestments. The meeting on 14 June will be key.

We think that the markets may be over-interpreting the significance of a shift in the ECB’s message. We assume that the ECB is still months away from hiking the refi rate and will act very gradually when it uses other tools (reducing bond purchases or increasing the deposit rate). EUR strength will only increase its caution.

It is thus very likely that the markets will review their expectations for future central bank rates and thus for the difference between bond yields over the coming months.

The expected gap in interest rates and economic momentum are key indicators for future currency movements (see chart). This suggests that the dollar should make a comeback soon.

Technical analysis, overbought indicators and concluding remarks

The euro is moving towards an overbought level against the dollar based on the Relative Strength Index (RSI). Indeed, the RSI is approaching 70 which is seen as a short-term indicator of overbought conditions.

In terms of technical analysis, a correction is expected and the 50-day moving average will be the first key support level at approximately 1.09 (value of 1 euro). The formation of a so-called “Golden Cross” (when the 50-day moving average crosses and breaks above the 200-day moving average) can be seen as euro-positive. There is no systematic pattern however.

We expect the dollar to rebound in the next few weeks/months and have a 3-month target of 1.06. Following our recent downward revision in US economic growth and upward revision in European growth, we have revised our target from 1 to 1.05.

The main risk factor to this scenario is an increase in political uncertainty in the U.S. leading the Fed to reduce the pace of interest rate hikes.