EUR-USD forecasts: return to the 1.14-1.15 area by the end of 2023

The US dollar experienced a strong recovery in May, with the DXY index rising from 101.21 to 104.50. EUR/USD reached 1.0720 yesterday June 8th.

During May, the dollar rallied as the market put aside expectations for Fed rate cuts in the coming quarters.

EUR-USD with 50, 100 and 200 days MA.

The day after the May 3rd meeting, the market was convinced that the Fed’s terminal rate (i.e. the peak of monetary policy rates) had already been reached (especially in the wake of the banking crisis triggered by the SVB bankruptcy). But the American economy is still working at full capacity: low unemployment rate, robust industrial production, plant capacity utilization rate at its highest, and access to credit still sustained by households and businesses despite interest rate increases. All these factors indicate unexpected resilience.

For the recession, we may have to wait longer. In fact, there may not be a recession at all. A slowdown yes, but not a recession (as claimed by Goldman Sachs’ research published on June 5th by Marketwatch.com).

Indeed, improving US macro indicators, including employment data, and resilient underlying inflation (core PCE at 4.7% in April, after 4.6% in March) have boosted expectations of a further hike in Fed Funds rates by July. Fed members also signaled further tightening, calling for an additional 25bps rate hike or maintaining the monetary status quo at current levels in the 5%-5.25% corridor.

In the very short term, the dollar will continue to depend on upcoming macro indicators (employment, ISM, etc.) and inflation data, especially on the decision taken by the Board of Governors ahead of the June 14th Fed monetary meeting. If these data continue to be strong, the Fed could still hike another 25 bps.

What then? In the second half of the year, the slide of the dollar beyond 1.10 will probably be emphasized by the expected recession/stagnation in the US and above all by the deceleration of inflation, which will again fuel expectations of a cut in Fed Funds rates for the meeting of mid-December 2023 / end of January 2024.

Mind you, the current relative strength of the dollar is not only a matter of US domestic demand and the Fed’s monetary policy, it is also a matter of the relative weakness of the euro. In fact, the euro was penalized by a cluster of fairly negative European macro indicators, as evidenced by the decline in the GDP index of the various Eurozone countries. The further contraction of German GDP by 0.3% Q/Q in the 1st quarter illustrates the current weakness of the European economy. This cannot fail to affect the euro-dollar exchange rate.

Meanwhile, European April inflation remained elevated at 7.0% year-on-year. Today the ECB deposit rate is 3.25%. Based on this still buoyant inflationary situation in the Eurozone, markets expect a 50bps increase in the ECB’s deposit rate to 3.75% by the end of July. With a first move of 25bps on June 15th.

Finally, another determinant of the euro-dollar exchange rate is the difference between government rates. The higher the Treasury–Bund rate differential remains in favor of the dollar, especially at the short end of the government curve, the more it supports the dollar in the short term.

In the Bloomberg chart below we can observe, from January 2022 to today, the parallel trend of the 2-year yields of the US Treasury and the German BUND. In the graphs below is the size of the US-GERMANY spread on the 2-year government bond.

As can be seen, the relative maximum of the US-Germany spread is 279 bps in July 2022 and remains around 250 bps until October 2022: and in fact, it was precisely in that period that the dollar reached remarkable intrinsic strength that even brought it below parity against the euro between September 2022 and October 2022. We are now at 170 basis points, in fact.

So different inflationary expectations, different GDP growth rates, and finally different central bank monetary policies drive the yield differential between the two currencies. This ultimately affects the euro-dollar exchange rate.

In the long run, it is also worth analyzing another determinant of the euro-dollar cross which is the trade balance between the two countries. But this last factor is not very significant for a short-term analysis of six months.

With the dollar expected to remain strong in June, the euro-dollar exchange rate will struggle to rebound beyond the fateful 1.08 threshold which is the 100g MA in the first table of this article (green line) in the short term. Indeed, in the short term, the dollar could even strengthen towards the 200d MA which is 1.0510, which is also the static support for the last 6 months. But at the end of summer, things could change, reversing the dollar-strengthening trend.

I actually believe that the dollar’s downward trend will begin in the autumn with increasingly cold inflation data and an increasingly accommodative "language" of the Fed for the economy. On the other hand, inflationary expectations in Europe will remain high, justifying the European central bank’s fundamental rigidity.

In fact, by the end of the year many analysts, in light of these different expectations for the two geographical areas, predict that the euro will return to around 1.14/1.15 against the US dollar (in December 2023 and at the beginning of January 2024). It is therefore worth continuing to invest in US government bonds, but only for very short durations, between three and six months. This is to benefit from the short-term relative strength of the dollar.

DISCLAIMER: the information contained in this article is believed to be true and updated as of June 9th, 2023. The considerations contained in this article are mine alone and do not involve the responsibility of Money.it and, at the same time, do not in any way constitute a solicitation of public savings. Investing in shares is a risky investment and may even result in the loss of 100% of the invested capital.

Original article published on Money.it Italy 2023-06-08 16:05:00. Original title: Cambio euro-dollaro, previsioni: ritorno in area 1,14-1,15 entro fine 2023