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Commerzbank research – How much upside potential does EUR-USD have?

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Commerzbank Research


How much upside potential does EUR-USD have?

EUR-USD is trading above 1.13  –  a  consequence of general USD weakness after the market’s re-assessment of the Fed expectations. Such levels, however, could prove to be unsustainable. The ECB policy will i.a. be influenced by the EUR exchange rates. The risk of a significantly more expansionary ECB policy is not properly reflected in the FX market.

For a long time the ECB was known as a central bank which was able to over-deliver compared to market expectations. This impression was destroyed by the December meeting. In December  the  ECB  significantly  disappointed  market  expectations  of  a  “strong” move,  by only delivering a small rate cut. And indeed: ECB President Mario Draghi’s old strategy – to create market expectations, which put the other Council members under pressure to deliver – failed spectacularly in December. That, however, does not imply that the ECB will always and forever be a paper tiger. Even under the assumption that Draghi did not find a sufficiently  large  majority  for  strong  measures  in  December  (which  would have  pushed  EUR-USD down),  we must concede: under different circumstances those who had opposed stronger measures in December might have behaved differently. And the relevant aspects of “circumstances”include the EUR exchange rates.

Yes,  of  course,  the  ECB  officials  will continue  to  formally  stick to  the  G7  London  accord, which implies that central banks refrain from manipulating exchange rates. This is the reason for Draghi’s regular statement that exchange rates would not be a policy target for the ECB.  Inside  the  London-accord  frame,  however,  the  ECB  does  everything  to  create  the impression that it would prefer lower EUR exchange rates. No wonder, as the exchange rate channel is the last one still functioning nearly normally. The ECB has all reasons to be concerned  regarding  inflation.  And  therefore  it cannot  afford to  accept  higher  EUR  exchange rates.  Elevated  EUR-USD  exchange  rates  therefore  increase  the  probability  of  stronger-than-expected ECB measures in March  – and therefore of a significant correction in EURUSD. The FX market is largely ignoring this risk. EUR-USD risk reversals trade at elevated levels. In fact only some days ago they printed in positive territory  –  a  situation we haven’t seen since mid-2009 (figure 1). The market obviously regards the risk of sharp down moves in EUR-USD as small.

In their central scenario our ECB watchers still assume that the ECB will indeed only deliver another small (10bps) rate cut in  March. This would certainly not create significant downward pressure on EUR-USD or other EUR exchange rates. This scenario still is possible.  But it is based on the assumptions that (a) financial markets calm down again and (b) EUR-USD  trades  at lower  levels  than  currently.  The  fact  that EUR-USD  can  gain in  phases of weak stock markets can only be explained by the market’s assumption that the ECB would hardly  react  on  negative  circumstances.  This  assumption  is  brave.  Every  day  of  financial market turbulence and every pip of higher EUR-USD quotes increases the probability of a more aggressive ECB.

For the medium-term (i.e. after March 10th) I see good chances for EUR-USD  –short positions. And I expect lower EUR-USD riskies again.


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