The key to recent broad USD weakness has been the reflation theme which has equally helped EUR/USD move higher by removing tail risks related to debt-deflation dynamics. In markets, this has been expressed by a high correlation of EUR/USD to a range of factors such as lower US real rates, EM FX, bank stocks, and, not least, credit spreads. However, the global cross-asset rotation as well as US vs EU factors seem to be fading and/or are well priced now. Economists at Danske Bank look for EUR/USD to retrace back to 1.16 in coming weeks.
Key quotes
“To maintain an optimistic EUR view, we have previously suggested to look at the financial canaries in places like ZAR, BRL and TRY vs USD, while notably DAX, financials and the travel sector should be leading the recovery. Over the past month, the tailwind from such a tactical rotation have been fading. Especially in Turkey, the fading momentum for USD decline is noticeable and the sharp level shift in TRY sends a signal that USD conditions may be changing. Due to similar structural issues with EU productivity (less so politics at the current point in time), the weak EM sentiment is increasingly a drag for EUR/USD.”
“The reflation theme appears to be stalling in equities: the growth factor keeps accumulating, and the post-earnings season is showing a continued advantage to technology firms - which favours the US. US companies' earnings surpassed Europe's during the COVID shock in March, and since then, US earnings estimates are rising at the same pace or faster than the best of Europe (DAX) while broader Europe lags). This factor will affect EUR/USD by weakness through drift, due to a continued wide productivity differential rather than from any particular view on future events. Arguably, the consensus view on Europe embeds an expectation of a catch-up and outperformance in Europe as visible in EUR/USD price action itself and/or real interest rate differentials. This does not seem warranted when viewed bottom-up from e.g. equities, nor relative COVID outcomes.”
“Positioning is well stretched long EUR and short USD, thus there is less scope for a 'surprise' factor to run further, everything else equal. Indeed, resilient US consumer and/or job data, or additional fiscal easing in US risk triggering USD strength.”
“Valuation is unfavourable. We revisited valuation in EUR/USD and our updated fair value estimate continues to run at 1.07 (based on cross-asset pricing) and 1.05 (based on relative productivity and terms of trade).”
“In sum, COVID-19 infused tailwinds for EUR/USD are fading while structural trends appear to be reasserting themselves, i.e. this time is not materially different (not even in euroland). We still target EUR/USD at 1.16 in 1M and 3M, with a revision of the EU vs US narrative a likely trigger.”
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