‘Sonata, Adagio & Minuet’: A ‘Symphony’ Of Debate Emerges Around Surging Euro

Ok, so we’ve seen what looks like some profit-taking in the euro after yet another pretty epic ascent on Wednesday, fueled by a dovish Fed.

Basically, the policy divergence theme that was supposed to underpin the rate differentials pillar for USD now looks even flimsier than it looked just a week ago. In fact, between Sintra (Draghi hawkish), Yellen on Capitol Hill (dovish), lackluster CPI in the US, and the dovish Fed statement, it’s no longer clear that the policy divergence theme makes any sense at all.

As a reminder, the euro has gained as much as 4% since Sintra, while EURUSD advanced as much as 5.3% at one point. Have a look at the following chart which shows you how the rates differentials argument has moved further in favor of the euro since Sintra:


(Admittedly, if you pan out on that chart, the euro seems to have run a little far ahead).

Notably, EURCHF crossed 1.12 this morning for the first time since the SNB abandoned the floor:


So what now? Well, that depends on who you ask.

Here’s the affable Kit Juckes (it seems like everyone at SocGen is affable – maybe Albert can confirm that):

We’ve written before about our belief that Fed balance sheet reduction will do less for the dollar than ECB tapering will for the euro. Fed QE pushed investors out of Treasuries into other ‘riskier’ dollar-denominated debt. ECB QE, turbo-charged with negative rates, pushed investors out of euro-denominated assets in general. The dollar rally came from economic outperformance, a far earlier start to Fed rate hikes and easy policy elsewhere. But anything that lowers expectations of where rates will peak is dollar-negative.

The danger is that we have a typical summer overshoot. By the time the ECB meets again, they may well find a euro is worth USD 1.20, which really won’t help their inflation forecast at all. That will, in turn, complicate the path of policy and at some point, we’ll get an FX response. The path from EUR/USD 1.20 towards the Big Mac fair value of 1.25, let alone the OECD PPP fair value at 1.33, won’t be in a straight line. But I mention those only to make the point that an economic bloc with a huge current account surplus can’t have both monetary policy normalisation and an undervalued currency.

That’s reminiscent of this, out earlier this morning from Richard Breslow:

They’ve frequently complained about the drag from dollar strength. In enacting a policy approach that is meant to stoke inflation from currency weakness they seem to believe that exporting deflationary pressures to the likes of the euro zone or Japan will go unnoticed, unremarked upon and ignored

It’s certainly been a home-run trade this year to be short dollars but don’t expect the ECB to respond to a hesitant Fed by becoming more aggressive in their tapering rhetoric. There’s going to be a lot more volatility as the market shifts back and forth on handicapping what could easily morph into a currency cold war of “He said, she said”

Ok, well, Barclays has a slightly different take. I’ve seen it floating around this morning, so I thought I’d excerpt it for you here.

Via Barclays 

Currencies, like symphonies progress through movements, not in straight lines. As a symphony progresses through the sonata, adagio and minuet, volume and intensity crescendos and decrescendos before the final forte surge of the rondo. Similarly, currencies can experience major rallies and sell-offs amid extended periods of range trading before a cyclical trend ever appears. The seven-month surge in the EUR from the nadir of its threeyear trading range to nearly its peak has felt like an Ode to Joy, particularly since the perceived defeat of populism in the French elections (Figure 1). In the process it has raised the question as to whether this is merely the sonata that will decrescendo back into the range of the adagio, or is this the breakout, the minuet that will lead to the finale of the symphony, and the EUR seizing G3 leadership from the USD? We have been surprised by the extent and vigour of the EURUSD move and have reevaluated our views from the bottom-up based on our framework. Based on our analysis, we still do not see the necessary conditions for a EURUSD breakout (yet). Rather, we continue to see a strong case for range trading, albeit a wider range with a higher centre point than we had previously forecast.

The USD continues to be overvalued based on all measures that we consult and its level on a real trade-weighted (REER) basis is near previous cycle peaks (Figure 2). The deviation of the REER from its long-term average at 9.2% is similar to the 12.5% overvaluation implied by our fundamental BEER model, but it is already about 7.8pp below its December peak. While the level is consistent with a cyclical peak, it would be a lower peak than those seen in 1985 or 2002 and, at both the tops and bottoms of past cycles, the USD REER has traded in wide ranges of 6-8pp over periods spanning years. This makes calling both the exact level and timing of the USD peak difficult.

Meanwhile, the EUR’s seven-month surge has erased any meaningful undervaluation of the common currency. The EUR REER is 3.3% below its synthetic long-run average and 0.8% below its post-inception average, the latter measure being in line with our BEER model misvaluation of -1.2%. The cumulative rise in the EUR REER since its March 2015 low has been nearly 9%. As a result, the EUR has lost two important sources of appreciation under our framework: pressure to appreciate from trade in goods and services based on the law of one price, and the investment activities of PPP-driven investors like reserve managers and some long-term private asset managers. Both forces should continue to be a drag on the USD, however.


We expect the USD’s already significant policy rate advantage to increase over our forecast horizon, particularly versus the euro, as the Fed steadily tightens policy amid building capacity pressures, while the ECB takes modest steps to remove exigent ‘insurance’ policies instituted to defend against deflation.

While a ‘parameter’ adjustment – as ECB President Draghi has called it – appears warranted given the improvement in the euro area economy and diminution of deflation risks, a sustained trend higher in ECB policy rates is not expected within our forecast period. As noted above, by the ECB’s estimate the euro area retains a significant negative output gap through end 2018 despite a steady improvement in resource utilisation. That output gap likely will continue to suppress core inflation rates (Figure 5) with potential drag from ‘Missingflation’. We expect the ECB to taper its purchases in 2018, slowing its rate of purchases to €20bn per month by the year’s end, and to raise the deposit rate twice by a total of 20bp by the second half of 2018. While less stimulative than current policies, under our forecasts the ECB’s QE program and negative nominal policy rates will remain in force through at least the end of 2018.

In contrast, sustained above-trend growth in the US with an already positive output gap should keep the pressure on the Fed to raise policy rates, despite soft inflation (Figure 5), until capacity utilisation ceases rising, which does not occur within our forecast horizon.


Our forecasts for US growth and Fed policy – 100bp of rate hikes by end 2018 – are predicated on a significant boost from fiscal policy in Q1 18, which is increasingly at risk from Congressional inaction. But, even without tax cuts, the US economy appears to have enough momentum to increase capacity pressures (albeit more slowly) throughout 2018, which should keep the Fed on pace to deliver on now modest market expectations for further tightening.

See? Simple.

No, but seriously, this is a notable debate and if we had to pick a side, we’d be inclined to go with SocGen.

Time will tell.


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