EUR: Failed to find any lasting support - Rabobank

Jane Foley, Senior FX Strategist at Rabobank points out that the EUR has failed to find any lasting support this morning from the record high reading in the June IFO report and instead the USD is recovering some ground, forcing EUR/USD back below the 1.12 level.  

Key Quotes

“While this morning’s action in EUR/USD suggests that for now a lot of good news regarding the German economy may be in the price, there is still plenty of uncertainty over the outlook for Fed policy which this week is likely to be impacted by data releases, US politics and Fed speakers.  This morning the Fed’s Williams stuck with the official line, predicting US inflation will rise to the central bank’s 2% target next year as unemployment edged lower and making the case for gradual rate rises.  Tomorrow, Fed Chair Yellen is one of several scheduled Fed speakers who will argue their cases ahead of the release of the US PCE deflator data at the end of the week.”

“In our view domestic US factors are sufficient to suggest that the Fed will have difficulty in complying with its own guidance with respect to interest rate hikes and potentially balance sheet reduction.   In addition, there are international factors which the Fed may be forced to contemplate.”

“In an essay presented in January, former Fed Chair Bernanke argues that “the growth in the public’s demand for currency is one (completely uncontroversial) reason that the Fed will need a larger balance sheet indefinitely”.  He points out that “today currency in circulation has grown to $1.5 trillion. Because of rising nominal GDP, low interest rates, increased foreign demand for dollars and other factors, Fed staff estimates that, the amount of currency in circulation will grow to $2.5 trillion or more over the next decade. In short, growth in the public’s demand for currency alone implies that the Fed will need a much larger balance sheet (in nominal terms) than it did before the crisis”.”

“There are echoes if these sentiment in the weekend release of the BIS’s annual report.  This contains a sector regarding USD funding risks which were prominent at the height of the global financial crisis.  While the USD funding risks in Europe have reduced since 2007, the BIS point out that they have grown in Japan and in Canada.  The BIS concludes that global US dollar funding markets are “likely to be a key pressure point during any future market stress episode. Non-US entities’ US dollar funding needs remain large, posing potentially sizeable rollover risks”.”

“While the Fed sets policy to suit US employment and inflationary conditions, international concerns regarding USD liquidity are likely to feature in the FOMCs deliberations.  While the Fed is already providing strong forward guidance in an attempt to avoid market shocks, there is a strong argument for the Fed to take a very cautious position on rates rises and balance sheet reduction.  We expect EUR/USD to remain consolidative on a 1 to 3 month view and edge high on a 6 to 12 month view on the assumption of a less dovish ECB.”