Euro: Window Of Upside?

Our FX strategists see asymmetric risks to the euro over the next 1-3 months.DIN-20141212-173326

The relationship between the euro and the ECB’s balance sheet broke down in the middle of the year. This could be a sign of currency traders front-running the ECB. The ECB has promised a lot and traders have aggressively shorted the euro. With the TLTROs and covered bond/ABS purchases having a muted effect (the take up for the ECB’s second TLTRO auction last week was underwhelming), traders are betting on an imminent sovereign QE. If the ECB fails to meet these expectations, currency speculators could begin to take profits on their short euro positions.

The sharp drop in oil prices further increases the importance of the ECB policy for the euro. The eurozone’s current account stood in a record surplus of €250 bn in the last twelve months. This has occurred even as oil imports have been steadily increasing. The eurozone’s oil import bill totaled over €300 bn over the last year. As this declines with lower oil prices, it will push the current account surplus to new record highs and exert greater upward pressure on the euro.

The way the ECB views the drop in oil prices will be vital. With headline CPI rising just 0.3% yoy, there is a reasonable chance that inflation could turn negative. If the ECB sees this as a temporary outcome and does not react with more monetary accommodation, the euro will be pulled higher by the growing current account surplus.

Our FX strategists are long the euro against a basket of the U.S. dollar and British pound.

Fed Outlook: Near-Term Versus Medium-Term

BCA’s medium-term House View is that the Fed will not be able to tighten much in 2015, and may even have to postpone rate hikes into 2016. But, robust job creation will sustain Fed talk of a mid-2015 rate hike in the near term.

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According to BCA’s medium-term House View, both economic growth and inflation will likely fall short of the FOMC’s expectations, causing the central bank to postpone rate hikes into early 2016. In part, this is because the biggest boost from the most cyclical parts of the economy (housing and consumer durables) is behind us. We also believe wages will be well behaved through 2015. At the same time, there are few signs of any positive momentum outside the U.S.

The world needs U.S. spending to be robust until demand elsewhere is on firmer footing. Until that happens, we fear that any attempt by the Fed to normalize interest rates in 2015 will be met by a surge in the dollar and possibly a rally at the long-end of the Treasury curve.

Nonetheless, in the near term, there is enough economic momentum at the moment to sustain upward pressure on the front end of the Treasury curve. Leading indicators suggest that job gains will remain solid over at least the next several months. Thus, FOMC officials may try to ‘talk’ market rates higher to close the gap between market expectations for the fed funds rate and the Fed’s outlook (i.e. the median dots). Also, there is a good chance that “considerable time” is removed next week.

Bottom Line: The FOMC is ignoring extremely low long-term inflation expectations in the face of a buoyant labor market. Robust job creation will sustain Fed talk of a mid-2015 rate hike in the near term.