Euro Exchange Rate 'Overreaction' Will Fade: ING

How the euro ends the week will rest with how stock markets perform this Friday. 

The euro shot higher during Thursday trade as Germany's DAX sold off steeply creating pro-EUR flow conditions. The single currency tends to perform well against a negative market backdrop owing to its status as a cheap funding currency.

This demand for euros, when combined with the US dollar sell-off inspired by the US Federal Reserve event, saw the EUR to USD exchange rate taken above 1.13 once more to test its best levels of 2016.

CitiFX Techncial analysts still see a constructive picture for EUR short term with resistance at 1.1318 which is a daily resistance trend line.

That said, Citi argue the medium to longer term outlook continues to point to a decline back towards 1.0700 though the dovish FOMC outcome is likely to delay the decline.

The euro to pound sterling exchange rate has meanwhile fallen to 0.7809 as the pound strengthens notably.Indeed, GBP/USD was the best performing currency of Thursday suggesting broad-based buying of sterling.

Interestingly, ING have labelled the sudden rally in the euro exchange rate complex over the past 48 hours as an overreaction to the US Federal Reserve’s tepid stance on raising interest rates in 2016.

Latest Pound/Euro Exchange Rates

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* Bank rates according to latest IMTI data.

** RationalFX dealing desk quotation.

 

Euro Overvalued

As the euro shoots higher, ING’s Petr Krpata warns the euro / dollar exchange rate is now overpriced.

“Eventually, we are likely to see a modest retracement towards the 1.10/1.11 level when the initial overreaction fades, we currently identify EUR/USD as being 1% overvalued, and risk remains bid, but a decline below this level needs an active catalyst from the USD side,” says Krpata.

ING aren’t necessarily advocating for a slump in the euro, rather a business-as-usual swing within recent, and familiar, ranges:

“The limited potential for EZ rates moving lower, following the ECB President Draghi’s indication last week that the ECB does not expect further rate cuts at this juncture, and market’s dovish take on the yesterday’s FOMC meeting,  whereby it may take time for US rates to move higher meaningfully, suggests a largely directionless and range trading environment for EUR/USD in coming weeks.”

That said, it is worth pointing out that the shared currency was rattled on Friday the 18th by the ECB's chief economist Praet gave an interview to the Italian newspaper La Republica and his comments rattled the euro a bit as he noted that the central bank could take the deposit rate further into negative territory.

Asked if the ECB has reached the lower limit of its interest rate policy Mr. Praet stated:

"No. As shown by the other central banks, we have not reached the lower limit. If new negative shocks worsen the economic scenario, a rate cut remains among our weapons."

Stock Market Performance Drives the Euro

The FOMC’s decision in favour of a dovish pause continues to resonate across global markets.

Risk appetite has generally benefitted from the downward revisions to the ‘dots’, which now imply two hikes this year down from four previously.

However, enthusiasm on European markets soon cooled thanks to negative developments on the German stock market which in turn stoked euro buying.

“Following a strong start to the morning things turned ugly with a sharp and sudden decline from the DAX dragging down its European peers,” says Connor Campbell at Spreadex, “the DAX was hammered by multiple directions this Thursday, causing the index to fall by nearly 200 points.”

Campbell attributes to the turn in fortunes in the German market to a host of drivers:

• Commerzbank and Deutsche Bank notably weaker following the latter’s CEO John Cryan warning yesterday that the bank wouldn’t be profitable in 2016
• Deutsche Lufthansa lower on a cut to profit forecasts due to increased cut-price competition
• VW and Daimler lower as the auto-sector remains precarious following last year’s emissions scandal
• The general impact of a stronger post-Fed euro

Why Would the Euro be Higher When Markets are Lower?

The impact of weaker markets has spread to other markets, the FTSE 100 included.

The euro benefits, as we have argued many times before, in times of market stress; it is likely to suffer when stock markets are rising and benefit when they are falling.

There are signs that incredibly large sums of money are starting to flow to riskier, emerging market, assets once more.

You can bet a significant chunk of these funds are in cheap-to-borrow euros.

This dynamic is testament to the latest cut in Eurozone interest rates - it is now cheaper than ever to borrow euros to fund stock market bets across the globe.

When these bets are unwound, and currency is repatriated, demand for euros rises. Indeed, if European markets endure further weakness we could well see the 2016 record broken.

"The 2016 high at 1.1376 is now in sight and if this level is broken, then the next stop could be 1.15," says Kathy Lien, analyst at BK Asset Management.

Inflation Also Boosts Shared Currency

There was further reason to buy euros on Thursday.

Eurozone inflation took an unexpected turn for the better, with the final February readings rising against expectations.

With the core annual CPI reading rising to 0.8% and month-on-month figure rising to 0.2%, there is reason to be cheerful for Mario Draghi, who will hope it is indicative of a future resurgence in price growth.

Euro strength could extend further yet.