Seeking Alpha

EUR/USD Long-Term Outlook

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Includes: ERO, EUO, FXE, UDN, UUP
by: Manuel Ortiz-Olave
Manuel Ortiz-Olave
Value, macro
Summary

The outlook remains bullish for the euro, although the dollar could trade higher in October.

However, when looking at long term valuation models the dollar is clearly overvalued.

EURUSD demand of call and put options has shifted positive for EURUSD. Markets currently pay a premium for EURUSD call options.

EURUSD outlook

The outlook remains bullish for the euro. My models suggest that the currency pair currently trades near its fair value, although other common long-term valuation models suggest that the dollar remains overvalued across the board. However, the dollar could show some strength in coming weeks as the Federal Reserve confirms a third rate hike before the year end, which simultaneously increases the likelihood of various additional rate hikes in 2018.

The euro has support at current levels, despite worse than expected inflation data in the euro area and the uncertainty related to the German elections and the Catalonian referendum. We believe this is due to Merkel's encouraging words towards Emmanuel Macron's ambitious agenda to work towards the unification of the Eurozone. This is a factor that would brace the case for a stronger euro, and depending on how the discussion evolves, the euro could continue to strengthen significantly.

Inflation releases in the US last week were worse than expected. Although these factors could be attributed to the summer tropical storms, it could also lead to additional caution from the Fed. Lael Brainard, the Fed's leading voice of the "dove camp", spoke twice last week without commenting on monetary policy. Ultimately her opinion is critical to tilt the balance towards a rate hike, as she blocked various interest rate hikes in the past.

I expect the dollar to trade higher in October, the labor market figures, which will be released later this week are particularly important, as it is expected a notable increase in wage growth. Should expectations be confirmed, the Fed could ratify, more aggressively, a number of interest rate hikes in coming quarters, including one before year end.

EURUSD: long term view

Nevertheless, when looking at long term valuation models the dollar is clearly overvalued. The Purchase Power Parity leaves no room for doubt, suggesting EURUSD fair value sits near 1.35, more than 14% upside.

The Real Effective Exchange Rate (source: Bank of International Settlements) also shows the USD is overvalued, despite the strong drop seen this year.

Statistical analysis

My model suggests EURUSD trades near fair value, in Q1 2017 the model pointed towards EURUSD 1.25. The slowdown in inflation in 2017 in the US increased the difference in real interest rates between the US and the Eurozone, which at the same time decreased the fair value designated.

However, I expect interest rate differentials to return to the historic mean-0.15% vs. actual 2.20%, which according to our model would imply EURUSD between 1.23 and 1.25.

Market Positioning

Looking at market positioning, for instance, we can see that EURUSD demand of call and put options has shifted positive for EURUSD. Markets currently pay a premium for EURUSD call options and they have been doing so since early June-4 months.

This did not happen since 2009 which clearly indicates that market sentiment towards the single currency has improved significantly, and supporting our view for further EURUSD upside in coming years.

Conclusion

Although EURUSD is under pressure nowadays due to a likely tax cut in the US, a more hawkish Fed and a possible more hawkish Fed Chair, long term valuation of EURUSD remains clearly bullish.

Companies looking to hedge EURUSD long term should have the above in mind and protect against EUR upside if needed.

Disclosure: I am/we are long FXE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.