In our view, the shift in the drivers of the EUR/USD exchange rate implies that the euro could be resilient amid further Fed rate hikes but continue to gain support as the ECB’s asset purchases near an end, according to analysts at Wells Fargo.
“Indeed, the Fed’s two increases in the fed funds target range this year and the additional hike expected in December have arguably had more of an influence on the U.S. two-year yield, which is up nearly 60 bps this year, than the 10-year yield, which is essentially unchanged year-todate. As long as Fed rate hikes continue to have a limited effect on 10-year yields, then any additional Fed hikes might only be a modest headwind for the euro. Meanwhile, once the ECB reduces its net asset purchases to €30 billion per month starting in January 2018, and as expectations build for an eventual outright end to net asset purchases, the euro should continue to gain on trend against a backdrop of higher longterm yields in the Eurozone.”
“In addition, by that time, expectations for eventual increases in Eurozone short-term interest rates will likely be building and have the potential to re-emerge as a factor of support for the euro. We will continue to monitor the evolution of correlations between yields and the euro to assess which elements of the ECB monetary policy toolbox appear to be the most influential for the euro over time.”
“One other consideration worth noting is the Fed’s balance sheet reduction plans, with those reductions scheduled to become greater in magnitude as 2018 progresses. Given these balance sheet reductions should have a more consequential impact on long-term yields than the Fed’s adjustments to short-term interest rates, they could become more of a headwind for the euro as 2018 progresses. However, by that time, the ECB’s asset purchases will likely be nearing an end, perhaps as early as September 2018, a factor which in our view should offset any potential weakness from Fed balance sheet reductions.”
“More broadly, in our view, the degree of adjustment in monetary policy that is likely to occur in the Eurozone in the coming quarters is of a greater magnitude than the adjustment underway in the United States, a factor which should also mean euro gains throughout the balance of 2018. In all, this analysis is supportive of our call for trend euro gains over the medium term, and we would reiterate that view with our 12-month EUR/USD target of $1.2400.”
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