Long EUR/USD for a move into the high 1.20s – Danske Bank

Analysts at Danske Bank suggest to go long on EUR/USD pair for a move into the high 1.20s via a bullish 12M seagull as they suggest that ECB is likely to unleash the power of EUR-positive flows despite ‘rate-hike gradualism’.

Key Quotes

“EUR/USD higher still on valuation and flow reversal The bounce in EUR/USD in the summer of 2017 was in our view just the beginning of what will prove a continued rebound in coming years. We see two main reasons for this.”

“First, the cross has been in undervalued territory for long as ECB-Fed divergence has dragged on: both our MEVA and PPP models suggest the cross is undervalued despite the level shift seen over the summer, with fundamental estimates from both models close to 1.30. Moreover, our currency-vulnerability scorecard points to USD in general being vulnerable to corrections, due partly to valuation and partly to external imbalances, whereas the opposite holds for EUR.”

“Second, while a fundamental misalignment may be sustained for an extended period in the absence of a trigger for corrections, we now see a clear driver for the euro. With the ECB having invoked on the path to ‘normalisation’, central-bank divergence is fading and should cease as an argument for selling EUR/USD from a relative rates point of view. Further, as market participants eye an end to QE purchases and the first ECB hike is drawing closer, a reversal in eurozone portfolio flows from the significant outflows seen in recent years to possible inflows should become a key source of EUR support. Projections of EUR/USD based on our rate-flow model for the cross of what could happen as the ECB exits unconventional measures suggest that 1.35 is within reach longer term.”

“We deem that the ECB is mulling an end to QE by the end of 2018, notwithstanding that eurozone inflation is set to remain weak. The latter should ensure that QE reinvestments remain extensive and that rates stay negative for a prolonged period, but it could unleash the next wave of ‘normalisation’ trades in the FX market. In our view, this will force another level shift in EUR/USD in mid-2018. At the same time, the Fed is looking increasingly hesitant due to a lack of inflationary pressure. This, combined with the potential for markets to price a Fed ‘inexperience risk premium’ in USD crosses more broadly, limits the potential for USD strength next year, even though we still think the market is pricing Powell’s Fed a little too softly.”

“Taken together, while the EUR-USD rate spread could move in favour of a lower EUR/USD near term, relative rates have not been an instrumental driver of the cross recently, and we believe that the EUR-positive ‘flow power’ factor will broadly dominate any rate-driven USD support in 2018.”

Long EUR/USD – the ‘flow(er) power’ trade

While unlikely to be a smooth ride, EUR/USD is set for a continued rebound in coming years and, thus, we like to be long the cross in 2018. This said, speculative positioning has turned net long and both the forward premium and positive skew are challenging. We see limited downside risks in the cross and, willing to cap upside around ‘fundamental value’, we suggest entering a bullish 12M seagull. Key risks include a more USD-positive policy mix in the US and/or an ECB hesitating on ‘normalisation’. In addition, with the trade being short volatility, a pickup in FX volatility is a risk.”

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