USD: Some key events in July have reinforced our belief that Federal Reserve forward guidance will come under the strain of diverging with reality as incoming economic data indicates better economic conditions than implied by the communication of the Federal Reserve.
Firstly, the semi-annual testimony by Fed Chair Yellen linked explicitly the continued improvement of the labour market with the risk of sooner and faster increases in the federal funds rate. Secondly, the FOMC statement from its meeting in July acknowledged improvements and progress toward achieving its mandated goals for the first time.
Given these developments we continue to expect higher US yields, in particular at the short-end of the curve as rate hikes in 2015 come in to focus. This will be key for lifting the dollar. Our Q2-2015 EUR/USD forecast remains 1.2700.
EUR: Short-term yields in Germany were flat to lower in July and long term yields were notably lower. In contrast to the US, the incoming economic data in Germany indicated a slowdown in economic activity, perhaps due to a decline in confidence related to the escalation of sanctions on Russia.
We suspect the yield story will not change over the coming months. There will be two LTROs, the first on 18th September and the second on 11th December, that will keep liquidity ample.
We also suspect, given price action in June and July, that the favourable support for the euro from narrowing periphery sovereign spreads has probably come to an end.
