Last week, our economics team made two significant changes to their policy rate hike expectations. First, our US economists now expect the Fed to announce a programme of 'incremental' asset purchases targeting a certain amount of flow each month (around USD100bn). They do not expect any upper limit for asset purchases but expect the length of the programme to be tied to improvement in economic data. Second, our European economists now forecast the ECB to be on hold for 2011 (previously we expected a hike in Q211). This change in view is driven by three factors: expectations of further QE by the Fed; further fiscal tightening announced in some countries (France, Portugal); and the upwards pressure on the EUR as an expression of the increasingly bearish USD sentiment. Given these changes, we have accordingly revised our EUR/USD forecasts to 1.42, 1.39, 1.35 and 1.30 in 1, 3, 6 and 12m, respectively (previously, 1.35, 1.35, 1.33 and 1.30). Therefore, we now expect a little more upside in the short run but then forecast EUR/USD to move back lower over the rest of the coming year. We discuss our reasoning for this below.
In our view, there are three reasons for the recent outperformance of EUR/USD:
1.
Increased worries about the US economy and the relatively dovish rhetoric from the Fed compared to the ECB.
2.
Increased international tensions, centred on the USD and the relationship between the US and other economies, specifically EM economies which target a certain exchange rate against the USD. The ECB has so far remained above the fray in this discussion and markets expect this to continue.
3.
Worries over the fiscal situation of peripheral euro zone countries have had little influence on the level of the EUR recently compared to the height of the peripheral crisis earlier this year.
We do not believe these factors will continue to be supportive of the EUR for very long. Although the market has turned increasingly bearish about the US economy, data have been fairly positive and more recently have consistently surprised to the upside (Figure 1). Our economists look for a modest pickup in growth while expecting a fairly significant slowdown in Europe after the surprisingly strong Q2 data. We expect data to increasingly weigh on EUR/USD. When considering the effect of economic data on FX, a lot depends on how central banks respond to economic data. It seems plausible that the Fed will continue to be significantly more dovish than the ECB but we think this is already priced in. The market seems to expect a significant increase in QE to be announced in the November FOMC meeting, and the risk seems to be that the Fed does less than is currently priced in. On the policy front, the situation remains uncertain and extremely difficult to forecast with conviction, but we think the current media hype on "currency wars" significantly overstates the issue. There is a risk that mid-term elections in the US could change the dynamic for the worse. Ahead of the G20 summit there may be more EUR upside from this - hence the 1m forecast of 1.42 - but that it will become less important as it becomes clear that the situation is not as bad as is currently feared. We discuss our views on the prospects for international coordination on currency policy in "Be careful what you wish for," FX Special, 7 October, 2010 (available here). We make the case that status quo is likely - with countries pursuing currency policy with domestic interests in mind - and headlines aside this has hardly been one of messy, competitive devaluations. We note that emerging Asian currencies have appreciated in recent weeks and despite the intervention efforts of Japan, the JPY has continued to strengthen. Finally, it's true that the peripheral problems are more about internal euro area issues than a mispricing between the euro area and the rest of the world, and consequently it is not clear that the EUR has a big part to play in helping to correct these internal imbalances. However, we are surprised by quite how much the FX market seems to ignore the peripheral problems. We expect euro area fiscal policy to carry on tightening more quickly than in the US, which should lead to very weak domestic demand. Put differently, the "periphery" is going to carry on saving and the "core" is unlikely to start spending quickly. Also, there are bound to be further internal political issues as the euro area institutional infrastructure gets addressed in light of the crisis. We believe this will make investors a little more cautious about holding EUR-denominated assets, and thus increase the risk premium on the EUR.
Figure 1: Recent US data have surprised to the upside...
Source: Barclays Capital
Figure 2: ...while euro zone data have been less supportive
Source: Barclays Capital
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