Consensus has been too bullish
We have been fairly bearish on EUR/USD for many of this 12 months, initially on the front-loaded Fed tightening cycle after which on the stagflationary shock generated by Russia’s invasion of Ukraine. And we had all the time felt that the greenback would most likely peak this 12 months given the home view that the Fed would most likely find yourself reducing charges in 2023.
Yet with EUR/USD now on the lows of the 12 months, our present end-year forecast of 1.08 paints us as bullish on the EUR/USD. This has been an uncomfortable view to current to clients and we now must take motion.
For reference, the chart beneath highlights how consensus has struggled to maintain tempo with this 12 months’s sharp decline in EUR/USD.
Consensus struggles to maintain tempo with EUR/USD drop
Valuation: The euro isn’t low cost
We do perceive that many company treasurers take sell-side FX forecasts with a big pinch of salt, however the warfare’s phrases of trade shock and what it means to EUR/USD honest worth has been a bearish improvement for the forecast profile. Back on 16 March, we mentioned that EUR/USD, buying and selling at 1.10, was 9% overvalued in actual phrases and was not low cost.
Returning to the difficulty of honest worth now, a fast recap. In our Behavioural Equilibrium Exchange Rate (BEER) mannequin, we estimate the honest worth in actual phrases of currency pairs based mostly on medium-term financial fundamentals: phrases of trade (the value of exports divided by the value of imports), productiveness, authorities consumption, and present account. Given the frequency of those information, the BEER honest worth is calculated on a quarterly foundation.
One constant statement that may be made throughout nearly all of G10 currencies is that the phrases of trade are on common the most important determinant of medium-term swings within the trade fee. This notion is especially related within the present surroundings, the place excessive volatility in commodity costs has generated important shocks in most nations’ phrases of trade positions.
Driving this phrases of trade shock – particularly for the euro – has after all been vitality costs. Our US economist, James Knightley, gives the chart beneath displaying the massive divergence between what the US and Europe are paying for pure fuel costs. And our European macro and sector groups appeared intimately in a latest article on the complete influence of fuel shortages on the European economic system. US vitality independence was all the time going to be excellent news for the greenback.
When it involves our EUR/USD BEER mannequin – which reveals good explanatory energy (R-squared of 0.70) – we are able to observe how the adverse influence on the equilibrium trade fee from the phrases of trade shock within the eurozone (brought on by excessive vitality costs) has been sizeable. In the chart beneath, we present how a lot every issue has contributed to the strikes within the EUR/USD actual medium-term honest worth in every quarter. The dampening impact of the eurozone’s phrases of trade could be very evident.
High vitality costs have dampened eurozone phrases of trade and EUR/USD honest worth
Despite the latest weak spot in EUR/USD spot, the drop in its BEER honest worth brought on by phrases of trade results was so important that we estimate the pair remains to be round 5% overvalued in comparison with its medium-term equilibrium stage (chart beneath).
EUR/USD mis-valuation from BEER honest worth
This is to not conclude that EUR/USD is sure to constantly trade beneath parity within the medium-term – as deviations from the honest worth throughout the 1.5 normal deviation band can final for a lot of quarters – however merely to point out how the euro isn’t wanting low cost when medium-term financial elements are taken into account. In order to “unlock” some materials upside potential for the pair, we would most likely must see an enchancment within the eurozone’s phrases of trade, or in different phrases, an easing of vitality costs.
Shifting the baseline situation
As above, FX forecasts usually are not the be-all and end-all to company treasurers and right here at ING, we discover it helpful to current a situation strategy. Back in June, we offered 4 such eventualities wherein our baseline (Scenario 2) noticed EUR/USD staying weak this summer season, however gently rebounding to 1.08 by year-end because the market’s consideration turned extra totally to the 2023 Fed easing cycle.
Given the latest discount in Russian fuel provides to Europe, and with our eurozone crew very involved by European development prospects this winter, we now really feel that Scenario 3 appears a extra possible baseline situation – and felt more and more uncomfortable with a ‘bullish’ EUR/USD forecast for year-end.
A reduce in our EUR/USD forecast profile is now extra according to our Rate Strategy Team’s view on the eurozone/US two-year swap unfold divergence. It has this unfold persevering with to maneuver in opposition to EUR/USD into year-end, with Fed easing expectations solely beginning to make their mark in 1Q23.
EUR/USD and two-year swap spreads: Actuals and ING forecasts
Combining macro, monetary policy, valuation and geopolitical views collectively, it now seems like the proper time to take 4-5% off our EUR/USD forecast profile curve.
Please discover our new set of EUR/USD forecasts within the desk beneath.
Our EUR/USD forecasts
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