There is no doubt that Europe’s response to changing US policies has been swifter and more definitive than expected. In isolation, stronger fiscal spending should be a powerful antidote to policy uncertainty and other maladies that have plagued the Euro.
As we have written since last summer, this is the way to a currency “deal” that would weaken the Dollar and satisfy a number of policy goals on all sides, though certainly so far this arrangement has come about through global discord rather than an accord. As a result of the shifting policy mix, we are revising our EUR/USD forecasts up to 1.07, 1.05 and 1.02 in 3, 6 and 12 months (from 1.02, 1.01 and 0.99 previously).
As discussed in the USD bullet, we maintain that the most likely path is Dollar appreciation—though from a weaker level and to a smaller extent—given the path of policy changes we still think are in the pipeline and high implementation risks for Euro area policy that have been quickly priced. That said, we also believe that investors’ increased attention on the upside scenario is well-placed.
If diminished “US Exceptionalism” gives way to finished, the Dollar can fall a long way and the Euro stands to be a key beneficiary. Portfolio inflows and strong asset performance have been central to the strong Dollar for more than a decade, and much of that has come from the Euro area. There is a clear playbook for this scenario, as it also played out in 2017.
During that time, more balanced global growth—at the time, it was largely attributed to China’s fiscal stimulus—led to a rebound in unhedged flows (back) to the Euro area, and the currency rose from about 1.05 to 1.25 over the course of a year, which closed the valuation gap against the Dollar. We rarely use valuation as the primary metric for sizing cyclical trading views, but it makes sense in this case when a possible change in the underlying cause for that valuation gap is central to the thesis.
However, valuation estimates also serve as an important caveat to overly bullish Euro views based on European policy changes alone. On a trade-weighted basis, the Euro is roughly fair (or even slightly overvalued) (Exhibit 2); the valuation gap is only on a bilateral basis against the Dollar (Exhibit 3).
The case for substantial appreciation therefore has to rest on the Dollar leg, which is a key reason why this is not our central case. However, we do see some of the ingredients coming together, and there is value in both sides of the Euro distribution.
