US Dollar rallies have been viewed with suspicion over much of 2016. Fluctuating Fed rate hike expectations linked to fragile risk appetite, market volatility, and patchy US data have caused many false starts for the US Dollar. Despite a brief period of optimism and Fed hawkishness, the Dollar seemed unable to sustain any stable upside momentum. However, this time around, the landscape has changed, and the US Dollar is finally following through to the upside.
Markets are again expecting the US economy to outperform against significant counterparties driven by the increasing gap between US yields and European yields whilst the stronger US Dollar has also weighed on Oil prices. Typically, Dollar strength alongside lower Oil would weigh on inflation expectations. However, the effect from tighter financial conditions to both equities and credit has so far been relatively muted as markets expect the incoming US administration to provide a strong offset in the way of fiscal, tax and regulatory easing.
Markets Awaiting First Steps From New Administration
There is likely to be some delay in receiving enough information on the new administration’s plans, potential growth impact, and political feasibility. Until this point, the market is largely operating around potential scenarios and outcomes. With 10 yr yields and equities around 2% higher than pre-election levels and the Dollar over 3% stronger, the market appears to be anticipating a budget expansion of around $1trln leading to a consistent path of GDP growth over several years. The current level of EUR weakness against the US Dollar is indicative of the extent to which the market is optimistic about the US growth outlook.
Given the level of the moves in bond, equities and the average strengthening of the Dollar against major and EM currencies, the Euro move looks fairly overstretched. However the Euro move is not solely attributable to the USD rally. The Euro is coming under significant pressure from a slew of upcoming political events in the EuroZone such as the French elections and the Italian referendum. Political events are taking on a great importance in their capacity as currency market catalysts following events such as the Greek referendum last year, the UK referendum and now the US election also.
Standing in support of the argument against EURUSD moving towards parity is the EuroZone’s solid current account surplus. Market-based growth expectations for the EuroZone are relatively when compared against the resilient EuroZone growth data. With the current move already containing expectations for a US growth boost, conditions could be lining up for the Euro to bottom, however, uncertainty remains at elevated levels. Indeed the upcoming European agenda is being viewed with greater trepidation in the light of recent political events.
There are three key pivots that the market must face now in determining EURUSD direction:
Policies from the Trump administration
Policies which boost GDP significantly, e.g., above 0.5% a year for a number of years, could lead to a further strengthening of the USD rally.
The French elections
Over the coming week markets will learn more about the right wing candidate who will challenge Marine Le Pen in next year’s election. Currently, Sarkozy who has typically polled poorly has dropped out. Candidates with higher approval ratings vs. Le Pen would likely reduce near-term uncertainty and provide support for EUR.
The Italian referendum
There is the potential for a no vote to cause market instability though could however also avoid tail risk outcomes near to the upcoming 2018 election more so than a yes.
The technical picture for EURUSD remains one of bearish pressure. Price has broken below the trendline support of the broader bearish channel and is now sitting just above key structural support at the February 2015 and November 2015 lows.