A Coy US Fed Maintains Euro/Dollar Exchange Rate’s Deadlock BUT Beware a Decline Over Three Month Timeframe

US dollar exchange rate

The euro to dollar exchange rate is forecast to retain current levels as the US Federal Reserve fails to pull the trigger to a US dollar recovery.

  • Euro vulnerable on a three month horizon warn Danske Markets
  • US inflation expectations could prompt a June interest rate rise at the Fed and thus prompt a dollar rally

There was always the chance the US Federal Reserve would surprise markets and stimulate a dollar revival by hinting that it could raise interest rates at its June meeting.

Initial currency market reaction to the Fed’s April statement suggested this was an outcome that markets had initially read.

However, a subsequent pullback in the US dollar complex betrays the markets’ initial assessment was overly bullish, and ultimately wrong.

The euro to dollar exchange rate conversion, having dipped, soon pulled higher on fresh USD selling taking it back into familiar territory.

“The FOMC wasn’t ready to give markets more guidance about an eventual rate hike at the June meeting,” says Piet Lammens at KBC Markets in Belgium, “EUR/USD hovered up and down, but finally closed the session in well-known territory at 1.1322.”

USD buying was stimulated as the FOMC dropped a previously held reference to global & financial risks posing risks for the US.

What disappointed dollar bulls was that the Fed’s language on inflation expectations remained unchanged despite the recent gains in oil prices.

This despite market expectations on the US inflation outlook have risen above December levels at which stage the US Federal Reserve was warning of up to four interest rate rises in 2016.  

The euro is therefore left ultimately directionless against the US dollar as neither appear to have the fundamental backing to justify a move out of current ranges.

“We see no trigger for a clear directional move in EUR/USD short-term. A genuine economic improvement in the US is probably needed to inspire a USD rebound. This trigger isn’t available right now,” says Lammens.

Therefore, continue watching the technical barriers defined by 1.15 to the top and 1.1250 at the bottom.

Euro Vulnerable on a Three Month Horizon

Despite the tight range seen in the euro/dollar of late we hear that we should expect further declines over the coming three months.

A key argument for a EUR/US dip near term is the potential for a temporary revival of relative rates, not least due to the fact that positioning is much closer to neutral.

Also, a cyclical situation set to evolve in favour of the US in coming months and the risk of a ‘Brexit’ also suggests to us that the cross could be vulnerable on a 3M horizon.

At the start of the year analyst Christin Tuxen at Danske Markets argued that despite the Fed having initiated a hiking cycle, he saw limited potential for tighter US monetary policy to send EUR/USD lower due to very stretched short EUR/USD positioning. 

The reasoning is that when investors are already positioned in one direction, the arguments to add to this position most be increasingly strong.

This has clearly failed to materialise as the US Federal Reserve has been increasingly unwilling to raise interest rates, allowing the EUR/USD to edge higher. 

"The pair has, in our view, gone a little too far considering recent moves in not least relative rates, both judged against moves in a 2Y swap and 10Y government-bond spread perspective," says Tuxen.

In addition, Danske's rate strategists look for US short-end yields to move higher ahead of September, when they expect the next Fed hike to be delivered.

Currently, the market is pricing a mere 60% probability of this and Danske Markets therefore expect to see US money-market rates edge higher in coming months as it becomes clear that the Fed is ready to continue its tightening cycle.

"On the whole, we thus see EUR/USD giving in on the downside to impulses from relative rates moving in favour of USD on a 1-3M horizon as positioning leaves room for this factor to play a role again for a while," says Tuxen.

Cyclical situation favouring US in 3M US data surprises have turned negative lately while the opposite has been the case for the euro area, but Danske's quantitative cyclical model, MacroScope, suggests that the US cycle will improve on a 3-6M horizon, whereas the opposite could be the case for the euro area.

"This should make the Fed more confident in continuing the hiking cycle and thereby strengthen the case for USD tailwinds in the short term," says Tuxen.