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EUR/USD: How High Can it Go?

Commerzbank HQ. © Andre Douque, CC licensing.

- EUR breaks higher after end to Italy stalemate.

- Other factors are also supportive of further gains.

- But will it go higher or is this just a ‘flash in the pan’?

The Euro-to-Dollar rate has risen strongly in recent days and analyst are becoming more optimistic in their outlook for it, but how high can it really go?

Europe's single currency has rallied in recent days after economic and political risks to the outlook were seen fading, enabling to clamber out of the 1.12-1.14 range it had been stuck in through December.

A recent poll of 44 forecasters, published by FX Street, is very bullish in its implications for the pair, especially over a 1-to-3 month horizon.

A total of 22 of the 28 institutional forecasters polled say the EUR/USD will rise over a 3-month horizon, leaving only 6 who expect it to fall. The most bullish is is Lloyds Bank, which forecasts EUR/USD at 1.24 in 3 months time.

Second is Unicredit at 1.19 and third is TD Securities at 1.18. CIBC Capital Markets forecasts EUR/USD at 1.17 in three-months time, while Societe Generale also points to 1.17. T

There is also a cluster of bank analysts who are forecasting EUR/USD at 1.15. 

 This gives us an idea of how high the exchange rate could trade over coming months but says nothing about the fundamental catalysts that might get it to those levels. What are analysts saying are the drivers behind the rally?

One of the main reasons analysts are becoming bullish in their EUR/USD forecasts could be diminishing political risk, with the Euro having risen of late after Italy and EU Commision finally reached a compromise on the former's 2019 budget.

This came after the austerity-busting budget concessions made by President Macron after the Gilets Jaunes riots in Paris. As a result of these France’s own budget deficit itself is expected to rise above 3.0% next year.

It was simply not possible for the commision to continue playing hard-ball with Italy in an environment where another country, France, was allowed to break the rules, according to Aila Mihr, an analyst at Danske Bank.

This could suggest a less austere fiscal environment in the Eurozone up ahead as other governments could more easily get away with caving to pressure from populists for greater public spending.

Above: Euro-to-Dollar rate shown at daily intervals.

Populist economic policies like those advocated in Italy and employed in the U.S. during 2017 tend to boost economic growth, which will be positive for the Euro if this happens over on the continent.

Another key factor supporting EUR/USD that could be the source of bullish forecasts is the Federal Reserve (Fed) having signalled it is close to the end of its interest rate hiking cycle, which is already weighing on the Dollar.

This could remain a positive influence over the EUR/USD, especially if the European Central Bank (ECB) sticks to its plan to lift Eurozone interest rates late in 2019. 

BUt the Fed was not as negative about the future course of interest rate policy on Wednesday as some thought, but this still hasn't dissuaded many analysts from suggesting rates will peak in 2019.

“Even if yesterday’s Fed announcement seems to have fallen short of dovish expectations, it should still be taken as another step towards a more neutral stance on monetary policy and if only on the back of becoming more data dependent.” Says Manuel Oliveri, head of currency strategy at Credit Agricole. “This implies falling USD rate advantage in an environment where other central banks such as the ECB are on track to normalize monetary policy as planned.”

One risk to the EUR/USD is that the ECB may not be able to lift its own ratenext year because Eurozone growth is currently expected to slow. Morgan Stanley cites this as a key risk to its bullish EUR/USD view and its bet the rate will reach 1.18 over coming months.

Yet there are reasons to think growth may actually pick up next year, not least of all because of the recent steep decline of the oil price. The recent fall in the price of crude could reduce inflation and lift real GDP over coming months.

EUR/USD could also be a beneficiary of its negative correlation with USD/CNY. The Renmimbi is now strengthening, pushing USD/CNY lower,  as trade war tensions ease and the government provides stimulus to China's economy.

“We think EURUSD is likely to rally from here. A strengthening of the CNY on the back of benign trade outcomes may support broader USD weakness, including against EUR,” says Morgan Stanley’s Redeker.

Another factor supporting upside for the pair is the overcrowded short trade that has been popular with the market since April, which could limit downside from here according to Credit Agricole’s Oliveri.

Oliveri says risks of a short-covering rally, where traders close their bearish bets en masse as prices recover and thereby encouraging a further recovery.

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