EUR/USD to 1.30 in 2018 – Deutsche Bank

George Saravelos, Strategist at Deutsche Bank, explains that as 2018 unfolds the market will grapple between duelling reflation forces in the US and Europe and they believe European forces will win out and would buy EUR/ USD targeting 1.30 over the year.

Key Quotes

“It's 2004-06 all over again

The Fed is hiking rates, US rate differentials are widening and the dollar has become a G10 high-yielder. This has been extremely $-positive in the past yet the dollar is not responding. Why? Current dynamics look very similar to the 2004-06 Fed cycle: back then the dollar weakened even as the dollar became one of the highest-yielding currencies in the world. The dollar's vulnerability in 2004-06 was a sharp deterioration in the current account: weaker flows mattered more than rates. We believe flows will matter more in 2018 too, but this time on the financial side. After benefiting from a big rise in portfolio inflows over 2014-16 the US basic balance has now peaked and inflows are slowing. Combined US equity and fixed income valuations are at 20th century highs and it will be extremely difficult to find the marginal buyer of US assets in 2018.”

“Fiscal policy not necessarily dollar bullish, trade policy might be next

Tax cuts may allow the Fed to keep tightening but the impact on the dollar could well be more ambivalent if flows matter more. Tax reform voted last year will mechanically push America's twin deficit wider by at least 2% in coming years and just like the basic balance turns here have historically coincided with turns in the dollar too. Add to this a potential shift in focus towards protectionist trade policy from the Trump administration in early 2018 and we note the best of the dollar policy narrative is behind us.”

“Much more to price for ECB

The European story looks far more positive. The dollar is no longer responding to Fed hikes because it already priced most of the exit around QE. The tradeweighted USD strengthened by a cumulative 25% around FOMC meeting days as the tightening cycle took off in 2013. In contrast, the euro has only appreciated 10% since ECB tapering began, suggesting EUR sensitivity to ECB tightening is likely to continue to be far greater than the Fed. Just like last year changes to ECB guidance and the FX reaction could take place well before the scheduled end date of QE in September.”

“Neutral rate matters for EUR/USD too

Relative neutral rates (the famous r*) matter for EUR/USD too. The market is not very responsive to Fed tightening because it does not believe it will get very far. The turn in EUR/USD last year coincided with a move higher in relative r*, which suggests more upside for the euro. Rising participation rates in the European labour market, healthier productivity growth, more upside to credit growth and structural reforms undertaken over 2010-12 suggest there may be more upside to European r* too in contrast to a Fed approaching neutral.”

“European structural under-weight still large

Finally, in contrast to the US, the European flow story is far more positive. European equity inflows picked up last year as the political and growth outlook improved. Fixed income flows may be next. ETF data from the top-4 European providers show that Europeans have amassed as many dollar assets as their holdings of domestic government bonds. Importantly these holdings are currency unhedged. Combined with a large current account surplus, it will be hard to fight positive European flows in 2018.”