Strong Euro - Beginning Of A Trend Or Temporary Euphoria?

Includes: FXE, UDN, UUP
by: Citylytics


The euro is now trading at its highest level against the dollar since the end of October as USA political turmoil dominates markets.

But it is not all Trump’s fault, the ECB has its share as well.

Sustainable euro strengthening is still unlikely.

The newspaper headline in recent days are full of suggestions that President Trump may have asked recently dismissed FBI director James Comey to drop his investigation into former National Security Adviser Michael Flynn. While Trump has denied such accusations, the rumors were enough for investors to react and markets to enter the risk-off tone. Needless to say that this has weighed heavily on the US dollar that depreciated by roughly 2.5% against the euro through the course of the week.

Let us not forget that in its interview on 12th April president Trump said: "I think our dollar is getting too strong, and partially that's my fault because people have confidence in me. But that's hurting-that will hurt ultimately." Well, it seems that Trump was right. Underlying reason for a greater part of dollar strengthening in past half of the year was the market believe that Trump will be able to deliver its pre-election promises, especially the ones regarding fiscal easing. However, Trump already disappointed market with his inability to gain support to repeal "Obamacare". After this latest scandal, it seems that the larger part of market participants is becoming worried that Trump won't be able to deliver the rest of the pre-election promises as well and that he potentially poses a significant political risk.

However, we must not forget that this scandal is not the only factor that played the role in recent euro strengthening versus US dollar. There are at least two other reasons. Political risks in the euro zone have fallen substantially as Emanuel Macron won the second round of French presidential elections against Le Pen. Furthermore, market expects for the ECB to announce further tapering of its quantitative easing as soon as in autumn. Indeed, the latter is in line with existing legal requirements of not holding more than one third of certain country outstanding bonds. However, markets are also speculating that the ECB might opt for a rate hike before mid-2018. In my opinion such outcome is highly unlikely. If closely looking at the ECB members speeches in the recent period, they are all indicating cautious optimism regarding euro zone economy. More importantly, all of them reiterate that inflation not only has to increase to its mid-term target but it also has to prove to be self-sustaining. In its recent speech Mario Draghi stated: "Nevertheless, it is too early to declare success. Underlying inflation pressures continue to remain subdued and have yet to show a convincing upward trend. The domestic drivers of inflation, namely wages, are not yet responding to the recovery and the narrowing output gap. Maintaining the current very substantial degree of monetary accommodation is still needed for underlying inflation pressures to build up and support headline inflation in the medium term." While euro zone inflation managed to increase by 1.9% y-o-y in April, its 'core' component increased by much lower 1.2% y-o-y. In such circumstances the ECB will likely keep its key rate low. Once the market becomes aware of the latter this temporary euro euphoria will calm down.

As for Fed, let's remember that FOMC members fed funds rate median expectations at the end of 2015 were standing at 2.4% for the end of 2017. At that point, nobody knew about Trump presidential winning and expected measures of fiscal expansion. Also, the FOMC had a clear rhetoric that their future policy stance is data driven and there has been no stronger discrepancies between Fed expectations and real data in the meantime. That being said, even without any measures of fiscal expansion there is no reason for Fed not to hike at least two time this year that would bring the upper limit of the federal funds rate just to 1.5%. Clearly, there is no justified reason for market June hike expectations to decline from 90% to just slightly above 60% only on the back of current political turmoil. Solid economic growth, accelerating inflation and unemployment rate at its natural level all suggest Fed has strong background for further hiking. That said, while euro might strengthen further in the near term, sustainable euro strengthening is still unlikely and US dollar will soon see fresh gains versus the euro.

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