The euro has continued the upward trend that started with European Central Bank President Mario Draghi’s speech in Sintra, Portugal. Its momentum gained strength following the July ECB meeting, in which Draghi said the governing council paid some attention to the euro re-pricing but did nothing about it.
We see downside risks to the euro’s strength since a strong euro is posing a threat to the ECB’s inflation projections and cannot be justified by interest-rate differentials.
Trade-weighted euro trades almost 4% higher since the June ECB meeting
We believe the recent increase in the euro should concern the ECB. The latest staff projections for euro-area inflation assume an unchanged trade-weighted euro over the next two years. However, since these projections were released, it has increased by almost 4 percent.
A rule of thumb suggests that a 10 percent rise in the trade-weighted euro reduces inflation in 12 months by 0.5 percent. Therefore, the ECB might be forced to lower its inflation projections by between 0.2 percent and 0.3 percent, which would put them even further away from their 2 percent target.
We expect the ECB to push against the strong euro ahead of the September meeting.
EUR/USD exchange rate appears to be too high given the current interest rate spread
Besides the potential ECB policy makers’ push-back against the strong euro, we also see risk from the interest rate side.
Core bond yields have fallen recently in the euro area while the currency increased. This means the EUR/USD exchange rate has strongly diverged from the current spread of two-year real rates in two years (2y2y) in the US and euro area.
Even looking further into the future, the market pricing for the 2y2y spread in one or two years doesn’t justify the exchange rate level.
Given the current interest rate spread, the EUR/USD exchange rate should trade between 1.10 and 1.12 and not above 1.18. We expect this divergence to be resolved by a tighter spread, in particular driven by higher real rates in Europe.
CHF weakness more driven by market technicals and not by interest rate changes
A similar picture to the EUR/USD exchange rate can be observed for the EUR/CHF exchange rate, which has increased to 1.15 from around 1.10 within the last two weeks. In our view the weaker Swiss currency is mostly driven by special factors, not interest rate movements or changes in private capital flows.
We believe the initial trigger was the recent initial public offering of Landis, which was previously owned by Toshiba. We think that once key technical levels around 1.12 were broken, stop loss accelerated the move.
However, we doubt that the Swiss National Bank (SNB) supported this upward trend via interventions. Sight deposits have remained almost unchanged in July, which suggests the SNB did not intervene.
Our year-end targets are for the EUR/USD to be at 1.20 and the EUR/CHF at 1.10
We expect the CHF to strengthen further against the euro and forecast the EUR/CHF exchange rate at 1.10 by year-end. We see this level due to the ongoing strength of the Swiss economy, which has digested the January 2015 franc shock.
If the ECB tried to weaken the euro, this would also be supportive of our view. In addition, the rates market helps as well. First, Swiss rates up to five years have almost moved in line with EUR rates, which implies the rates market does not price a significant policy divergence between the ECB and the SNB.
Second, the SNB has almost stopped intervening in FX markets and thereby also stopped its balance sheet expansion while the ECB continues to expand its balance sheet.
Therefore, the flow side of the balance sheet is supportive for the CHF. The EUR/CHF FX at 1.10 would be fair given the current one-year carry differential between EUR and CHF rates.
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