Euro / dollar outlook: yields should favor the dollar, coronavirus shocks could derail expectations

• Live Euro to Dollar exchange rate: EUR / USD 1.12796 (-0.12%)
• Case of transient inflation under high pressure
• Powell appointed for a second term
• Yield trends should support the US dollar
• The ECB sticks to the dovish script….
• … .But the Hawkish pressure is increasing
• Coronavirus worries euro confidence (EUR)
• Immunization rates also increase the vulnerability of the United States



• Slightly overvalued US dollar (USD)

Central bank policies will inevitably be a very important determinant of major exchange rates.

Inflation fears have increased in the euro area and the United States. But the ECB has insisted more that the pressures are transient and reiterated that it will not tighten monetary policy.

In contrast, the US Federal Reserve is expected to tighten policy more quickly.

Yield spreads should support the dollar, especially if the eurozone is hit by the new wave of coronavirus cases.

The pendulum could tip sharply, however, if the United States is hit by an increase in the number of coronavirus cases and the economy deteriorates, with the Fed forced to back down quickly.

It is also important to note that the consensus forecast in early 2021 was for further dollar losses, but the US currency registered notable net gains.

Above: EUR / USD exchange rate chart

The euro / dollar exchange rate (EUR / USD) fell to a 16-month low just below 1.1200 before rising to near 1.1300.

Case of transient inflation under high pressure

While inflationary pressures intensified earlier in 2021, central banks remained convinced that higher inflation rates would be transient.

Inflation rates, however, rose much more than expected with the US headline rate above 6.0% and the highest rate in over 30 years. Other measures of inflation also rose sharply.

Danske banknotes; “Transitional†has lost its credibility considerably and we are likely to see another negative environment for the euro as manufacturing growth slows. “

In this context, there has been a shift in expectations regarding monetary policies and a surge in inflation expectations. In particular, the Federal Reserve should adopt a more restrictive policy.

Danske Bank added; “A sharp surprise on the rise in CPI inflation in the United States only added to the movement, highlighting the risk that inflation may be more persistent than the Fed expected and thus fueling upside expectations 2022 rates. “

ING also points to recent US data; “The release of the Fed’s preferred inflation measures for October saw the stock and core PCE stand at 5.0% and 4.1%, respectively – new cycle highs – and market prices of the Fed cycle remain firm. “

Powell appointed for a second term

Fed Chairman Powell’s first term will expire at the end of January 2022. In recent months, there has been much speculation that President Biden would prefer a candidate more closely aligned with the broader economic and political agenda of the United States. administration.

In particular, there was speculation that Governor Brainard would be appointed president on the assumption that she would adopt a more conciliatory policy.

As it happened, Biden appointed Powell for a second term, raising expectations that there would be a slightly more hawkish central bank.

MUFG commented; “The decision removes a source of uncertainty for financial markets and favors the continuity of the Fed’s policy. The risk of a potentially slower pace of political normalization under a new Fed chairman such as Fed Governor Lael Brainard has been ruled out. “

Nomura also expects a faster pace of Fed tightening; “If inflation accelerates, as we expect, and other signs of this widening remain, the risk is that the market assesses earlier / faster tightening (either an acceleration of the reduction or rate hike) and maybe more hikes until 2023. “

Yields should support the dollar

According to ING; “In 2022, it seems clear that the Fed will have the main reason for applying some monetary restriction and that the dollar should behave well.”

The Fed announced in November that purchases of bond purchases would be phased out, with bond purchases to be completed by mid-2022.

However, there has been growing speculation that a strong economy and higher inflation will lead to a more aggressive stance by the Fed with a first rate hike by mid-2022 at the latest.

There is a strong consensus that rates will be hiked at least once in 2022.

Rabobank noted; “Essentially, the reasons we expected the dollar to outperform this year still hold true. This is linked to the expectation that the debate over a possible federal funds rate would emerge much sooner than an equivalent move by the ECB and many other major central banks. “

In recent comments, Fed Governor Waller noted; “The incoming data prompted me to favor a faster rate of reduction. Vice President Clarida added; “It may well be appropriate at this meeting to have a discussion about increasing the pace. “

Wells Fargo Expects Sustained Dollar Strength; “We now expect an extended period of US dollar strength and widespread greenback strength through to the third quarter of next year, and maybe even later, about six months longer than our previous forecast.”

According to MUFG; “With global yields expected to rise further against the Eurozone, this is a factor that could further weigh on the performance of the Euro in the coming months. “

Danske is also examining a potential trigger for further euro losses; “The risk of pushing EUR / USD below 1.10 is a scenario in which central banks tighten further amid a cyclical downturn, similar to a scenario like the early 1980s.”

The ECB sticks to the dovish script …

Although there has been a shift in the global debate, the ECB has continued to assert that the increased pressures will be temporary.

Bank President Lagarde said the conditions for raising interest rates are unlikely to be met in 2022 and added; “We must not rush into premature tightening in the face of transient or supply-induced inflationary shocks.”

ING noted; “The ECB has made it clear that it does not want to repeat the mistakes made by Trichet in tightening its policy in July 2008.”

MUFG notes that the bank wanted to push back the doubts of the market as to the sustainability of the policy; “For this reason, the Council argued that it was important for the ECB to be vigorous in its guidance in order to ensure that credibility was maintained.”

… but the Hawkish pressure is increasing

Several members of the ECB, however, have expressed concerns about the development of inflation and will inevitably push for a more hawkish turn.

Nordea commented; “There probably isn’t a lot of disagreement about signaling that rate hikes are very unlikely as early as next year. However, there will likely be more disagreement over what to do with buying in. ‘active.’

Goldman Sachs sees possibility of euro rally next year; “We believe EUR / USD may fall below current level over a shorter horizon, but expect a rebound thereafter according to our basic outlook for growth and policy on both sides of the Atlantic .

Coronavirus concerns undermine confidence in the euro

The number of coronavirus cases in several euro area countries has risen sharply, especially in Austria and Germany with a new containment in Austria.

Comments from Danske Bank; “As the northern hemisphere heads into winter, new cases of COVID-19 are on the rise, leaving countries with low vaccination rates most vulnerable. “

MUFG expects there to be a direct impact on the weakening euro, but also a secondary impact on stimulating demand for dollars as global growth stumbles; “The reality that COVID is poised to play a disruptive role in economic activity across Europe, and possibly beyond, this winter is hitting currencies other than the dollar. “

He adds ; “The euro takes the lead on the downside, but increased uncertainties about global growth will benefit the dollar overall.”

Immunization rates also increase the vulnerability of the United States

Over the past week, the focus has been on the eurozone. Nevertheless, there has been an increase in global concerns following the discovery of a new variant in South Africa that has a high number of mutations and could make it easier to evade vaccine protection.

Marshall Gittler, head of investment research at BDSwiss Group, points out that the United States has the lowest vaccination rate of any major economy.

If a new variant gains traction around the world, the United States could also be particularly vulnerable.

Above: Table of vaccination rates

If the US economy deteriorates, large budget and current account deficits could also increase the dollar’s vulnerability.

Slightly overvalued US dollar

Barclays says the dollar is overvalued at current levels; “Under two widely used approaches, the relative PPP and a BEER model, we find that the USD basket relative to the G10 (at equal weight) is slightly overvalued in the 5-10% range. “

He adds ; “We anticipate a modest depreciation of the dollar over the coming year, reflecting our vision of a stable environment for risk and commodities as well as a moderate overvaluation of the dollar.”

BNP Paribas adds; “The USD has been overvalued since 2019”. According to its latest model, the euro is undervalued by around 3.5%.

EUR / USD forecast table

Pair	place	1 month	3 months	6 months	12 months
Bank of America	1.13	1.14	1.13	1.12	1.10
ING	1.13	1.16	1.15	1.11	1.10
CIBC	1.13	1.14	1.12	1.11	1.10
Goldman Sachs	1.13	–	1.14	1.16	1.18
Nordea	1.13	1.14	1.14	1.12	1.08
JP Morgan	1.13	1.14	1.13	1.12	1.12
Agricultural credit	1.13	1.15	1.15	1.16	1.19
Wells fargo	1.13	1.11	1.09	1.08	1.07
Barclays	1.13	1.15	1.16	1.19	1.19
BNP Paribas	1.13	1.15	1.14	1.13	1.12
RBC Capital Markets	1.13	1.14	1.13	1.12	1.14
Danske Bank	1.13	1.14	1.13	1.12	1.10
Nomura	1.13	1.12	1.10	1.14	1.18