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Deutsche Bank: EUR/USD Headed to 1.30 as Eurozone Reflation Trumps US Price Pressures

deutsche bank exchange rate forecasts

All of the recent inflation talk in Europe is water under the bridge for EUR/USD. Relative capacities for growth in economic activity, jobs and inflation will matter more for the two currencies in 2018.

The Euro-to-Dollar rate could headed for another double vintage year in 2018, according to strategists at Deutsche Bank, who say the common currency could rise by a high single digit percentage and is an outright buy for speculators.

Europe’s common currency is likely to win a tug of war with the US Dollar, driven by reflation forces on both sides of the Atlantic, as a renaissance of price pressures on the old continent trounces those in the new world.

“As 2018 unfolds the market will grapple between duelling US and Euro reflation forces. We believe European forces will win out and would buy EUR/USD,” says George Saravelos, a G10 foreign exchange strategist at Deutsche Bank.

Economy watchers in Europe wouldn’t necessarily know that Eurozone inflation is likely to rise over and above the rate of US price pressures.

US inflation may have meandered up and down in recent months but it is already close to its target, while President Donald Trump’s tax cuts may add further to it still, given they are expected to boost economic growth a touch in the next year or two.

Meanwhile, Eurozone inflation took a step backwards in December and not for the first time in recent history. It also remains some way off from the 2% target.

Most importantly the core inflation rate, which removes volatile commodity items from the price basket, broke above the 1% threshold twice in 2017 but failed to hold onto its gains. It has now failed twice to break back above the 1% level. 

Core Eurozone inflation remained stable at 0.9% in December when economists had hoped for a 10 basis point increase to 1%.

Core inflation in the US is forecast to hold steady at 1.7% for December when the number is released Friday, after dropping 10 basis points back in October.

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“The European story looks far more positive. The dollar is no longer responding to Fed hikes because it already priced most of the exit around QE,” says Saravelos.

“In contrast, the euro has only appreciated 10% since ECB tapering began, suggesting EUR sensitivity to ECB tightening is likely to continue to be far greater than the Fed.”

In layman’s terms, the recent US-Europe inflation dynamics are all water under the bridge. What will matter more for currencies in 2018 is the capacity for further increases in economic activity, jobs and inflation.

This is what will dictate how much scope there might be for further increases in interest rates, whether in the US or Europe, and the level of potential upside to rates is a bigger driver for currencies than individual changes in interest rates themselves.

Markets seem to think the Federal Reserve is fast approaching the upper limit for US interest rates, at which point further rises will become harmful to the economy and merely beget even lower rates in the future. So traders have become less and less willing to reward the Dollar with a stronger bid each and every time the Fed moves.

“Relative neutral rates (the famous r*) matter for EUR/USD too. The market is not very responsive to Fed tightening because it does not believe it will get very far. The turn in EUR/USD last year coincided with a move higher in relative r*, which suggests more upside for the euro,” Saravelos writes, in a recent note.

The neutral rate is a simple economic concept that dictates the extent to which any interest rate must move upward or downward to reach the point where monetary policy is neither expansionary nor contractionary for the relevant economy. In short, it is the “equilibrium rate”.

“Rising participation rates in the European labour market, healthier productivity growth, more upside to credit growth and structural reforms undertaken over 2010-12 suggest there may be more upside to European r* too in contrast to a Fed approaching neutral,” Saravelos says.

The Euro rose by 13% against the US Dollar in 2017 for several reasons.

First, markets lost faith in the Trump administration’s ability to light a fire under the US economy that would be sufficient enough to justify the extent to which they had bid the Dollar higher in the wake of the President’s election victory.

Second, the European Central Bank gave the common currency an adrenaline shot when Mario Draghi suggested at conference in Sintra back in that the bank could soon begin to wind down its quantitative easing program, given a solidifying economic recovery on the continent.

It has since announced the first reduction in its bond buying program, beginning a process that could conclude as soon as September, which opens the door for it to begin raising interest rates.

“Finally, in contrast to the US, the European flow story is far more positive. European equity inflows picked up last year as the political and growth outlook improved. Fixed income flows may be next,” Saravelos argues.

International investors, particularly American money managers, dumped the Euro by the bucket load during the Eurozone debt crisis and never quite rediscovered their appetite for European financial assets until last year. Further “portfolio flows” into the Eurozone could be a big driver for the currency this year.

The combined effect of all of these factors, according to Saravelos, will be an increase that takes the Euro-to-Dollar rate back up to 1.30 over the course of 2018. This would be its highest level since 2014.

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