Via Goldman Sachs,
We last made a meaningful downward revision to our EUR/$ forecast in August, just after ECB President Draghi’s speech at Jackson Hole. At the time, our message was that EUR/$ has begun a protracted weakening trend, reflecting cyclical underperformance vis-à-vis the US and a more activist ECB, which would take the single currency to parity versus the Dollar by 2017. We are revising down our forecast further today, to 1.14, 1.11 and 1.08 in 3, 6 and 12 months (from 1.23, 1.20 and 1.15 before). We are also revising down our longer-term forecasts, bringing the end-2016 forecast to 1.00 (from 1.05) and that for end-2017 to 0.90 (from 1.00). These changes underscore our view that the recent slide in the single currency is part of a broad trend, which will see EUR/$ undershoot 'fair value' (around 1.20) on the weak side.
We are revising our EUR/GBP forecast in a similar manner, to 0.75, 0.74, 0.73 in 3, 6 and 12 months (from 0.77, 0.76 and 0.75), while keeping the end-2016 and end-2017 numbers unchanged at 0.70 and 0.65, respectively.
More broadly, our conviction in the strong Dollar theme has grown. As part of that, and also reflecting the drop in oil prices, we are revising our outlook for the commodity currencies weaker. We revise our AUD/$ forecast to 0.79, 0.77 and 0.75 in 3, 6, and 12 months (from 0.83, 0.82 and 0.79), with our end-2016 and end-2017 forecasts also at 0.75. We revise our $/CAD forecast to 1.19, 1.20 and 1.22 in 3, 6, and 12 months (from 1.13, 1.14 and 1.15), with our end-2016 and end-2017 forecasts at 1.24 and 1.26.
The sovereign debt crisis in Europe arguably ended mid-2012 with President Draghi’s important “whatever it takes” speech and the subsequent creation of the OMT program. However, a growth and competitiveness crisis continues unabated, and this forms the backbone of our EUR/$ lower view. Exhibit 1 shows the average drop in the real effective exchange rate across nine emerging market crises in number of months from the start of the crisis at t. It shows that emerging markets have tended to see real devaluations of around 30% during the kind of balance of payments crises that the Euro periphery has also seen (a sudden stop to capital inflows that financed large current account deficits). Meanwhile, real exchange rates on the Euro periphery have stayed high, even with the recent slide in EUR/$, so that the kind of competitiveness boost that emerging markets tend to see post-crisis remains elusive.
At a very basic level, we draw two lessons from this: (i) deflation in the Euro area has a structural element, given how high periphery price levels still are; and (ii) given still high periphery price levels, the kind of growth rebound typical in emerging markets is unlikely, as Exhibit 2 shows.
This sets the stage for protracted cyclical underperformance vis-à-vis the US (Exhibit 3) and deflation / disinflation, which our persistence-weighting makes out to be the most severe in the G10 (Exhibit 4), even before recent sharp falls in oil prices. As a result, we see the recent slide in the single currency as part of a broad trend, which will see EUR/$ undershoot 'fair value' (around 1.20, based on our GSDEER model) on the weak side for a protracted period. In particular, we think that if ECB policies manage to convincingly raise inflation expectations, EUR/$ may fall more than implied by nominal rate differentials.
At the same time, we have gained conviction in our Dollar bullish call. Our view has been that the fading of Fed forward guidance is an important positive for the Dollar, because it allows front-end US interest rates – the main driver of the Dollar versus the majors – to rise. Exhibit 5 shows that the Dollar strengthened following both the September and December Fed meetings, which downgraded the “considerable time” language. In September, Chair Yellen emphasised the Fed’s data dependence during the press conference, while in December she ruled out lift-off for “a couple of meetings”. Of course, the recent drop in oil prices may mean that the Fed could delay the timing of the first rate hike, which our US economists flagged this week. At the same time, this week's FOMC minutes showed that the Fed is taking a relatively benign view on the fall-out of Dollar strength for the economy. Overall, we continue to see the fading of Fed forward guidance as a Dollar positive, which should continue to see the 2-year differential converge higher towards the forwards (Exhibit 6).
As part of our growing conviction in the Dollar, and also reflecting recent oil price declines, we are revising our outlook for the commodity currencies weaker. We are marking down our AUD/$ forecast to 0.79, 0.77 and 0.75 in 3, 6, and 12 months (from 0.83, 0.82 and 0.79), with our end-2016 and end-2017 forecasts down to 0.75 (from 0.79 previously). We are revising our $/CAD forecast to 1.19, 1.20 and 1.22 in 3, 6, and 12 months (from 1.13, 1.14 and 1.15), with our end-2016 and end-2017 forecasts at 1.24 and 1.26. On a trade-weighted basis, the combination of our forecasts sees the Dollar strengthen around 7.0% versus the majors over the next year and cumulatively by 18.5% by end-2017. We expect the Euro to weaken around 5.0% on a trade-weighted basis versus the G10 over the next year and 15.7% through end-2017.