Euro-Dollar Rate Bought by Nordea and Sold at SEB, but Only One Can be Right

Image © European Union 2018 - European Parliament, Reproduced Under CC Licensing.

- EUR at inflection point, June 19 Fed meeting a moment of reckoning.

- Nordea Markets says buying EURUSD 2nd best idea out there today.

- As Nordic rival, SEB, tells clients to sell EUR as Fed will stand pat.

The Euro-to-Dollar rate is a likely beneficiary of any decision by the Federal Reserve (Fed) to cut its interest rate and buying it is the second best idea out there right now, according to strategists at Nordea Markets, although SEB Bank is telling clients to sell the single currency and only one of the two can be right. 

Europe's unified unit saw an eventful start to the month and is no doubt at an inflection point following the June meeting of the European Central Bank (ECB) governing council and ahead of next week's Federal Reserve rate decision. 

ECB President Mario Draghi came across to the market as much less concerned about the outlook for the Eurozone economy than many investors had thought he might be, and financial markets are increasingly busy betting the Fed will cut its interest rate on multiple occasions before the year is out. 

The recent turn of events around two of the world's most significant central banks explains why the Euro rate bounced so heartily last Thursday and how it's managed to retain the initiative against a weakening Dollar. 

"A long EUR/USD position is the second-best G-10 FX trade in the three months leading up to the first Fed cut, only outpaced by a long EUR/NZD position," says Nordea's Andreas Steno Larsen. "EUR/USD has picked up during the 60 trading days preceding the first rate cut from the Fed in five out of the last six rate cutting cycles – with the 1989 cycle as the sole exception."

Above: Euro-to-Dollar rate shown at weekly intervals, alongside the Dollar Index (orange line, left axis). 

Investors had been betting to at least some extent all year that the Fed will cut rates later in 2019 but, in May, the wagering against the U.S. economy increased dramatically. That increase came alongside an escalation of the U.S.-China trade war and after a series of surveys pointed toward a sharp slowdown in the manufacturing sector, which were taken as signs the U.S. economy is slowing more rapidly than markets anticipated. 

Now, financial markets are in the process of determining whethe the Fed is likely to cut rates twice or on three occasions this year and next Wednesday's Federal-Open-Market-Committee meeting expected will be instrumental in moving that process along. If the Federal Reserve says or does anything to suggest markets are right in betting on multiple rate cuts the greenback could suffer and the Euro-to-Dollar rate rise steeply. 

"EUR/USD often moves lower again 6-12 months into the cutting cycle, probably as the ECB tends to follow the Fed with a time lag," Larsen says. "We see EUR/USD at 1.16-1.17 before a correction lower towards 1.12 in 2020 (as US growth will likely rebound by Q1-Q2 2020)."

Larsen and the Nordea team forecast the Euro will rise to 1.16 by the end of September and to 1.17 in time for the end 2019. SEB Bank says there's a "significant risk" of a much higher Euro-to-Dollar rate later this year but that in the short-term, the single currency is likely to fall. 

Above: Nordea chart showing market expectations of Fed policy action, and policy actually delivered.

"Two opposing forces are dominating the dollar outlook: relative rates/central bank policy and risk appetite/safe heaven flows. If the global economy continues to slow down, without the Fed rate cuts the dollar is likely to continue to strengthen as safe heaven flows will dominate and euro hedging ratios remain low," says Richard Falkenhall, a strategist at SEB.

Changes in rates are only normally made in response to movements in inflation, which is sensitive to economic growth, but impact currencies because of the influence they have on capital flows and their allure for short-term speculators.

Capital flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency. Rising rates have the opposite effect.

Falkenhall and the SEB team say the Federal Reserve will not cut its interest rate this year, although they acknowledge the risk of such a move has increased lately. If this forecast is correct then once markets realise they've been wrong in betting on rate cuts, the Dollar could experience a boost. 

Above: SEB graph showing Euro-to-Dollar rate and various EU-U.S. interest rate differentials.

"For euro to strengthen considerably, we believe the Fed needs to cut policy rates to reduce the hedging cost for euro based investors, the USD curve to steepen and risk appetite to improve. This is not imminent," Falkenhall writes, to clients. "The Fed may have hard time to outdove the market next week."

Falkenhall told clients Thursday they should sell the Euro-to-Dollar rate and remain 'short' so long as the exchange rate is below 1.1380. He's targeting a move down to 1.1150 over the next three months or so. 

Next Wednesday's Federal Reserve decision will be either the moment that investors are vindicated for betting the way they have done, or the moment that the penny drops and they realise the U.S. central bank is not yet in panic mode.

Both scenarios would have significant implications for the Euro-to-Dollar rate.  


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