The Dollar Comeback Should Be Temporary

What explains the recent dollar comeback?

The EUR/USD, which had been relatively range-bound between 1.22 and 1.25 between February and the end of April, has rapidly fallen to below 1.16 in the past weeks. Several factors have led to the USD strengthening.
First, the divergence in economic momentum between the United States and Europe has reached levels not seen since 2008. Indeed, while the eurozone experienced a sharp softening of economic indicators in the first quarter of 2018, the US economy remained strong. This is especially true, judging from the economic surprise index which measures the economic data surprise versus expectations of market participants. The second key driver is the rise in US yields relative to Germany. Indeed, while the Federal Reserve is firmly committed to continuing to raise interest rates, the European Central Bank adopted a cautious stance at its last meeting due to sluggish inflation and weakening economic data. This was reflected by the further rise in the difference in 2-year interest rates between the US and Germany which reached a high since 1989. This so-called  interest rate “differential” in favour of the dollar has been growing in recent months but the trigger for markets to focus again on this indicator probably occurred when more extreme levels were reached. Finally, the build-up of a general consensus of a dollar weakness led to a large short USD positioning (speculation over a fall in the dollar) accumulating until recently. Such extreme levels often lead to sharp turnarounds, which was again the case this time.
 

Limited upside for the dollar from current levels

In a previous publication, we argued that the euro appreciation had become self-sustaining and that US dollar weakness was running counter to economic fundamentals. This was especially true regarding the relative economic momentum and the interest rate differential, as discussed in the previous section. The recent dollar strength has normalized the excess and there is little reason to see further dollar strength except for a deeper political crisis in Italy and the eurozone.

Indeed, looking at the differences in economic momentum, we have already reached quite extreme levels but it is unlikely that the gap will widen. There is a mean reversion pattern that is fairly common and we expect a catch-up effect in the eurozone.

When it comes to central banks, we expect the US Federal Reserve to hike rates four times in total this year and twice next year. This would take the level of the Fed fund rate to 3% by the end of next year. The ECB is not expected to raise its policy rate before autumn 2019 and anyway the increases would be very gradual. Looking at the interest rate differential based on the 2-year yield, we have reached record levels and our central bank outlook does not suggest a further rise from current levels.

In terms of technical analysis, the EUR/USD has fallen below both the 50- and 200-day moving average (see chart above). The move towards 1.155 was a key test and the level could be retested temporarily. We however change our 3-month target to 1.19 (from 1.22). 
 

The outlook for a weaker dollar in the medium term

Looking beyond short-term factors, several hurdles to USD appreciation should remain. The Trump administration’s tax reform should see its effects diminish after 2018 and should have a major impact on twin deficits (current account and public deficit) and federal government debt levels in the coming quarters. In the medium term, the key driver will remain the Purchasing Power Parity (PPP). It measures the exchange rate that equalizes the price of a representative basket of goods when calculated in dollars. The estimated long-term fair value for one euro (“Purchasing Power Parity” or PPP) provided by the OECD is around 1.28 (based on Germany’s figures). We do not expect this level to be reached in the coming months but it is  more likely on a multi-year horizon. We still forecast the EUR/USD at 1.22 on a 12–month horizon.