EURUSD: Performance over the medium term dependent on monetary policies - Natixis

Nordine NAAM, Research Analyst at Natixis, explains that the performance of EURUSD pair over the medium term will be dependent once again on monetary policies on each side of the Atlantic as the French elections risk has passed.

Key Quotes

 “The French presidential election kept the EUR/USD on tenterhooks for several months, as there were a number of populist candidates calling for a Frexit who were expected to do well. As a result, the EUR/USD has been very closely correlated to the risk premium priced into the OAT-Bund spread since the start of the year. Since the first round of the election on 23 April, the EUR/USD has rebounded to 1.095, tracking the tightening of the OAT-Bund spread. Following Emmanuel Macron’s victory on 7 May, the pair rebounded to a high of 1.1023 on 8 May, probably in reaction to the squaring of short euro positions held by speculative accounts (20 thousand contracts). Speculative accounts are now neutral, while the options market are sending the same signal, as 3-month Risk Reversals 25D are near zero.”

“After a high on 8 May, the EUR/USD went back on the retreat, pulling back below 1.09. The pair’s performance over the medium term will be dependent once again on monetary policies on each side of the Atlantic. The next big date on the agenda is the 8 June meeting of the European Central Bank, which is expected to be marked by a return to a certain neutrality on the part of the central bank so as to prepare for a QE recalibration in H1 2018, which could be announced next September. However, this scenario is starting to be priced into the Eonia forwards, which reflect hikes in key monetary policy rates one year out given the stronger growth and the disappearance of deflationary risks. In this respect, note there is a certain correlation between changes in Eonia forwards and the EUR/USD. In this context, it seems rather unlikely the market will start to turn buyer of the euro over the short to medium term. In the absence of a rise in short-term interest rates, M.Draghi will endeavor to contain the rise in long European rates.” 

“The EUR/USD will also be influenced by expectations concerning the Federal Reserve’s monetary policy. As indicated by the righthand chart above, the Fed Funds curve has steepened anew from the 1st to the 15th contract, indicating that there are heightened expectations of a hike in the Fed Funds rate. The slope between these contracts is only 60bp. This corresponds to less than three hikes in the Fed Funds rate by the summer of 2018, which is underwhelming, even though we have shaded down our own scenario, which is now for three hikes in 2017 (instead of the four anticipated back in 2016) and still for three hikes in 2018. As expectations of these hikes heighten, this should bolster the DXY dollar index in coming weeks, in the run-up to the 14 June FOMC meeting.”

“In the meantime, there will be a series of speeches by FOMC members to prepare the markets for the June tightening. The June hike has just about been priced in, not the next ones however. One should therefore witness a further steepening of the Fed Funds curve and a firmer US dollar.”