Strict implementation of a simple yield differential model, based on data back to 2014, suggests that EUR/USD should be trading closer to parity, notes Morgan Stanley.
"Many would say that the ECB announcement that policy is to be reviewed in December has had the desired effect of taking EUR lower. But given the US yield adjustment which has taken place in anticipation of a December Fed lift-off, for EURUSD at least the decline has been moderate.
The fall in EUR TWI has been even more limited. This moderate reaction is the result of conflicting drivers for EUR," MS adds.
Thus, MS argues that while policy divergence and yield spreads point lower for EURUSD, challenges to the global risk picture are an opposite force, supporting EUR.
"Equity and commodities have been under renewed pressure, adding to the factors that are set to undermine the global risk picture, in our view. A stronger USD against the EM currencies is also risk-negative, and EUR-positive," MS notes.
"Even the gradual EUR weakness seen so far has the potential to develop negative feedback on risk via EM and AXJ in particular, implying that the EURUSD move lower could be slow at this stage," MS argues.
MS targets EUR/USD at 1.06 b year-end and runs a limit order to sell EUR/USD on rallies into 1.11.
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