Euro-to-Dollar Rate: “Time to Buy a US Dollar Lottery Ticket” say Nordea Markets

-Tax reforms are hoovering Dollars from the international market.

-Fed's detente with the bond market is also effecting liquidity.

-USD strength to push EUR/USD to 1.2150 according to Nordea.

-Trumpism to push EUR/USD to 1.18 say Commerzbank.

© jcomp, Adobe Stock

The US Dollar could be overdue a rebound higher, according to strategists at Nordea Markets, who are flagging changes in the interest rate market that traditionally lead to a stronger Dollar.

This is likely to be bad news for the Euro-to-Dollar rate, which has spent the best part of the last month ceding the initiative to the greenback, marking a break with an order that had previously propelled it to a 17% gain for the year to February 16.

Nordea’s is just the latest in a choir of voices that have been calling for an end to the rout that pushed the US Dollar index, which is a measurement of the Dollar relative to a broad basket of currencies, down by more than 10% over the 12 months to the middle of February.

“Since 2014 the DXY index has lagged the development in the amount of excess liquidity in US Dollars by 2 months. If this correlation doesn’t break, it will mean a relative big strengthening potential for the USD over the coming quarters,” says Andreas Steno Larsen, a senior FX strategist at Nordea Markets.

Larson and the Nordea team have flagged a widening gap (spread) between the cost of borrowing US Dollars at the London Interbank Offered Rate (LIBOR) and the rate in the US Dollar overnight index swaps market, which closely tracks the Federal Reserve’s main interest rate.

Above: Nordea Markets graph showing LIBOR-OIS spread (Blue) and US Dollar index (Red).

The LIBOR-OIS “spread” (above) has doubled from around 25 basis points to more than 50 basis points (0.5%) so far in 2018. The cause of the move has been a rise in the LIBOR rate, which is the rate banks charge each other to borrow over short periods.

“Fewer USDs will float internationally, due to tax-reform related repatriation of USDs from abroad and due to Feds quantitative tightening,” Larson explains.

Nordea attributes the expected scarcity of US Dollar assets to the Federal Reserve’s diminishing involvement in the bond market and President Donald Trump’s tax reforms, which appear to be acting like a vacuum cleaner that is hoovering US Dollars from the international financial system.

“Recently, the LIBOR-OIS spread has been leading the DXY-index by roughly 2 months. If that is the case this time around also, it is another reason to believe in a stronger USD,” Larson adds. 

Larson and the Nordea team suggest the US Dollar might soon start to follow the so called LIBOR-OIS spread upwards and that the Euro-to-Dollar rate could be among the casualties of this climb.

“We stay tilted towards a little lower EUR/USD short-term and await how the correlations develop,” Larson writes, in a note Monday. “Current target is 1.2150, but we will assess the development along the way. Another way to play our USD risk scenario is via a USD lottery ticket in the options space.”

The Euro-to-Dollar rate was quoted 0.28% higher at 1.2319 during noon trading in London Monday.

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

Larson and the Nordea team are not the only strategists now touting a more optimistic US Dollar view.

“The addition of Larry Kudlow to Trump’s economic team and Trump’s increased anti-trade rhetoric triggered our 0-6M upgrade,” says Greg Anderson, an FX strategist at BMO Capital Markets.

Anderson and the FX strategy team at BMO Capital Markets upgraded their forecasts for the US Dollar index Monday.

Chief among reasons for this is the “King Dollar” preference of President Trump’s choice for National Economic Council director, Larry Kudlow, and the prospect of a trade tariff war. A tariff spat with other countries is seen supporting the greenback in the short term, given the spell of uncertainty it would cast over the global economy.

“If Kudlow becomes the de facto spokesperson for America’s FX policy, his rhetoric could cause FX investors to further trim their net short-USD short positions,” Anderson writes. “The US appears to be preparing to wage a trade war. This may help the USD in the short term because it uncertainty favors the USD. It could help in the long term if it reduces the US’s trade deficit (and the need for inflows to finance it.)”

BMO’s forecast upgrade marks an about turn from the decisively pessimistic stance the bank held just a few months ago. However, in addition to this upgrade, other strategists are also calling for the US Dollar to rise from the ashes in the months ahead.

“Rising US government debt on the back of the Trump administration’s expansionary fiscal policy is often blamed. However, the early 1980s remind us that such a policy argues for a stronger dollar in the medium-term, and a protectionist trading policy would generally support the dollar,” says Ulrich Leuchtmann, head of FX strategy at Commerzbank.

“Consequently, current USD weakness, which is likely to be due primarily to market-based factors, is unlikely to last much longer. We anticipate a stronger dollar by year-end.”

The 10% decline in the US Dollar index during the last year has been driven by many factors although, more recently, most strategists have flagged the so called “twin deficits” as the cause of the Dollar’s woes.

Tax cuts are expected to see American consumers selling more Dollars to buy more imports while the Federal government borrows more money from overseas to plug the anticipated whole in the budget deficit.

This gave rise to fears of a larger twin deficit, covering both the current account deficit and budget deficit however, Leuchtmann’s team predict this phenomenon should fade over the coming quarters, enabling the greenback to regain the initiative over its international rivals.

As a result, the Commerzbank team forecasts the Euro-to-Dollar rate will fall to 1.21 before the end of June, before declining steadily to 1.18 before the end of December. This implies a 4% drop for the EUR/USD rate during the months ahead.

Advertisement
Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here.

 

 

Need Help? WhatsApp me.

Horizon Currency's dealing desk is here to answer any questions you have about the market. 

Sam is one of our specialists and can be WhatsApped questions via this link.