EUR/USD Target Change

Summary

1.The dollar strength over 2021 and 2022 was mainly driven by a risk-off environment and rising rate hike expectations for the Fed due to the sharp increase in US inflation in the US relative to the eurozone.

2.We have defended for some time the argument that the dollar is overvalued especially as we moved closer to parity (one euro equal one dollar) at the end of 2022. As we will discuss, the fair value level (based on Purchasing Power Parity) is estimated around 1.37 (value of one euro).

3.Fundamental drivers such as the interest rate differential and relative economic momentum point to a durable trend change with more dollar weakness. What has supported the dollar until recently was the high uncertainty around interest rates and the consequences of the Ukraine war.

4.We are now more confident that the fundamental drivers will gradually dominate as uncertainty should continue to fall over the coming year. The volatility in the US bond and interest rate markets (Move index) remains high but should gradually fall. Short-term, we cannot exclude a temporary rebound of the dollar.

5.We revise our 3-month target to 1.08 (from 1.06). For the 12-month horizon, we revise up our target from 1.08 to 1.15 (value of one euro). This suggests more dollar weakness.

Fundamentals suggest a weaker dollar

We think that the interest differential will continue to move in favor of the euro. Indeed, in the US the Fed raised rates by 25bp on May 3rd, which sets the key rate to 5.25%. This should be the terminal rate (end of the cycle) We do not expect the Fed to cut rates this year, unlike the market. The Fed should start cutting rates late Q1 2024. 

In Europe, the ECB hiked another 25bp on May 4th and we expect a similar hike in June, setting the terminal rate at 3.5%. We do not expect rate cuts this year. The ECB would start cutting rates only after the Fed. The 2-year yield differential has been moving in favor of the euro and this suggests more weakness for the dollar.

The economic momentum has also started to turn more positive for the eurozone recently as uncertainty fell and supply side constraints eased (supply chains). The risks related to the conflict in Ukraine are much lower. We also expect the economic activity to fall more in the US as interest  rates and in particular mortgage rates rose more relative to the eurozone. In the US, we expect a recession albeit moderate and short-lived. The eurozone should keep positive growth rates. The economic momentum should thus stay in favor of the eurozone for some time. This should be another key driver of the expected strengthening of the euro. 

Medium-term drivers

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 1.37 dollars (based on Germany’s figures). Deviations from PPP can however be seen over a long period. Some academic studies suggest that a more relevant approach would be the so-called notion of half-life*. Following Craig (2005) “a half-life represents the amount of time that elapses before a discrepancy between the PPP level and the current exchange rate is half its current size”. He found that for large differences that period could be around 12 to 18 months. Currently, the notion of half-life suggests a value of one euro of 1.23.

Over a one-year horizon, we expect a gradual recovery for the euro from current levels. Indeed, geopolitical uncertainties should fall gradually while the yield differential should stay in favor of the euro. We revise our 3-month target to 1.08 (from 1.06). For the 12-month horizon, we revise up our target from 1.08 to 1.15 (value of one euro).

Short-term risks of a dollar bounce

The technical analysis suggests a rebound of the dollar. Indeed, the rise in the EURUSD (value of one dollar) has been quite sharp and current levels diverge from the moving averages. Short-term, we think that the most likely path is towards the 50-day moving average around 1.08.

*For example, see B. Craig (2005) “The Growing Significance of Purchasing Power Parity”, Federal Reserve Bank of Cleveland, Economic Commentary.