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A perfect negative storm is brewing for EUR/USD by year end: Royal Bank of Scotland

Having not made any aggressive downside EUR/USD noises for many, many months we now sound the early alarm. There is a negative storm brewing for EUR/USD.

From Royal Bank of Scotland, by David Simmonds

We think about the EUR/USD exchange rate in terms of three explanatory variables:

First, interest rate differentials (of course): Rate spreads have already moved very far in favour of the USD over recent months.

Second, relative Fed and ECB balance sheet size: We expect things will move significantly in the Dollar’s favour over coming months: First as TLTRO take-up means the size of the ECB balance sheet re-expands quite rapidly; second as the Fed balance sheet finally stops expanding (more or less) with the final Fed taper in October.

Third, and pivotal, is Euro zone periphery risk. In our rich/cheap FX strategy work, we use 10Y Spanish yields as an input. The rampant periphery rally ever since ‘that’ speech from ECB President Mario Draghi two years ago has been a strong explanatory driver of EUR FX resilience. European rates research colleagues have had a magnificent call on this and maintain a bullish periphery view from here. They are still looking for 10Y Spanish yields to fall further, driven by another circa 45bp of Spanish tightening to German Bunds (to +100 bp in spread). In FX strategy we have been thinking ourselves about a late, last (?) melt-up in periphery prices, melt-down in spreads over the summer.

The periphery rally, on-going, has been the main reason why we have opposed consensus USD bullishness for many months, preferring a counter consensus view of a EUR/USD drift higher. Periphery strength explains much of how EUR/USD has been able to defy the gravity of a rate differential story that has moved so significantly against the EUR. Other important factors supporting EUR resilience have been a persistently large Euro zone current account surplus (on-going) and reserves diversification demand for EUR (on-going as reserves growth in Asia and beyond has recently re-accelerated). Periphery strength, current account surplus and a diversification bid could yet hold EUR/USD up for longer.

Ultimately, a lower EUR/USD probably needs to go hand-in-hand-in-hand with a revival in global market volatility and (in turn) with a more durable move higher in front end USD rates. A crushed vol environment isn’t an environment where EUR/USD goes anywhere fast and this does not (quite yet) feel like Vol Resurrection time. Meanwhile, markets are already bearish (price) front end US interest rate futures.

BUT the important takeaway from the Janet Yellen testimony yesterday is that the era of Fed guidance is emphatically now finished. The era of complete data dependence has emphatically now begun. Almost by definition that is a bit of a ‘vol stirrer’.

On forecasts, we have EUR/USD falling to 1.27 at year end. For reasons mentioned above, we still think of this as more of a Q4 kind of move. But it could be sooner. Having not made any aggressive downside EUR/USD strategy noises for many, many months we now sound the early alarm. In our view, there is a negative storm brewing for EUR/USD.

We see this more as a EUR/USD story than a Cable story because of the relative monetary policy argument – ECB is still easing and is en route to QE next year. The Fed is not easing (or won’t be beyond October) and Bank of England is well on its way to monetary tightening. Trade weighted GBP should still hold up well, EUR/GBP goes lower.