- The FED’s dovish shift has significantly reduced downside pressure on the euro in recent months and mounting political pressure to ease suggests a neutral outlook for EURUSD.
- Over the longer term the euro should see slight upside pressure as its stronger fiscal position keeps inflation relatively anchored.
Short-Term / Tactical Outlook: Euro No Longer Overvalued
The recent dovish shift by the Federal Reserve has removed a major downside force acting on the euro and while our short-term fair value model still suggests slightly downside for the pair, mounting political pressure on the FED suggests the euro’s bearish run is nearing its end.
*Numbers 1-5 reflect order of historical importance in driving the currency pair. **Negative sentiment towards the currency/economy is views as contrarian bullish. See here for a more detailed understanding of short-term currency drivers.
Our fair value model for EURUSD has shifted starkly in recent weeks from suggesting sharp euro downside to just mild downside following the drop in US bond yields and steady euro weakness. Our model is based on the spread of German over US inflation-linked bond yields of varying maturities, as well as measures of speculative positioning. Currently it still implies slight further downside but the trajectory of the fair value model suggests the door is closing on further dollar gains.
Indeed, the FED’s policy bias is looking increasingly dollar negative as President Trump’s attacks on Chairman Powell are growing in intensity and the bank’s thin veil of independence is being pierced. The ECB meanwhile continues to push back its projections for rate hikes amid renewed weakness in inflation expectations, but real yields have actually seen some upside pressure in recent weeks in contrast to the US. While there is no doubt that the ECB would like a weaker euro, there is little scope for a major dovish shift. Technically, the pair remains locked in bearish trend with no signs of divergence in market positioning or sentiment to suggest a breakout anytime soon. Further choppy sideways trading appears to be the most likely option over the coming months.
Long-Term / Structural Outlook: All Signs Point to Steady Euro Upside
Over a multi-year period we should expect mild euro strength despite a slightly inferior growth outlook as inflation remains below that of the US over the long term due to favourable fiscal dynamics. Slight euro undervaluation should also provide a tailwind.
*Assumes a 1 percentage point increase in productivity improves fair value of currency by ~0.5% based on the Balassa-Samuelson effect. See here for a more detailed understanding of the key long-term currency drivers.
Weak Demographic Outlook to Impede Eurozone Growth: We expect real GDP growth to average slightly lower in the eurozone relative to the US despite a similar productivity outlook as the single currency block faces an even sharper decline in its working-age population relative to the US. Regarding productivity, while the eurozone scores lower across the board in our productivity indices, its relative underperformance is in line with its lower level of GDP per capita.
The eurozone scores particularly poorly in relative terms in its Business Environment and Economic Freedom with not even the freest and business friendly economies in the bloc able to compete with the US. We also judge political stability to be slightly lower in the eurozone as it faces similar levels of political polarization but with the added risk of religious tensions in certain states and non-negligible risk of disintegration. The eurozone scores higher than the US in just one category – Financial Risk – as despite the threat posed by deeply negative real interest rates, we do not see the kind of systemic risks we see in the US which exhibits extreme levels of government and external debt combined with an equity market bubble.
*Contribution from savings rate gain/decline reflects the natural demographic effect of an increase/decrease in the proportion of the country’s population that is of net saving age.
Eurozone Inflation to Remain Lower for Longer: We see inflation pressures in the eurozone remaining muted over the longer term thanks in part to the improvements seen in the bloc’s fiscal position over recent years, with deficit- and debt-to-GDP levels falling sharply in contrast to trends in the US. A superior external balance sheet should also provide support given the lower likelihood of net portfolio outflows relative to the US, whose net international deficit now stands at almost 50% of GDP.
From a money and credit perspective neither the US nor the eurozone faces strong prospects for private sector credit creation, while the potential for continued rapid government debt growth seems higher in the US should voters begin to favour the Democrats’ increasingly ambitious fiscal proposals, particularly with regards to healthcare.
Valuations Slightly Favour the Euro: Despite the euro being slightly overvalued in the short term, longer term metrics such as the real effective exchange rate and the fair value implied by average price levels and GDP per capita suggest slight undervaluation. As the chart below shows, the real exchange rate between the euro and the dollar has followed the euro below its long-term average over recent years. We estimate that this level of undervaluation should add an additional 0.4 percentage points onto annual euro appreciation over the next decade.