A 'Moderate' Continuation of Euro Exchange Rate Strength Seen, Dollar Still Looking Shaky

Euro exchange rate recovery

The euro has declined against both the British pound to US dollar over the past week but our studies show that it is far too early to call an end in the shared currency's strength.

The euro to dollar exchange rate is looking to form a support base from which it can stage a recovery having experienced days of losses.

Ahead of the new week the pair is seen at 1.1285 having fallen from highs above 1.14 registered at the start of the week.

The euro will also be looking to restart its advance against the pound sterling having fallen to 0.7957, down from 0.8074 on Monday.

The euro was actually the second-worst G10 performer against the US dollar in the week gone by, only the Swiss franc lost further ground.

The biggest gainer was the Australian dollar.

But, what we are seeing is a mere pause in the move higher by EUR/USD argue researchers at Italy’s largest bank, UniCredit, who say upside pressures on the pair should remain. 

However, strength will likely moderate, unsurprising if we consider the pair is trading towards the top of historical ranges.  

ECB is Main Driver of Euro Over Coming Days

Dominating the euro exchange rate’s outlook over coming days is the April meeting of the European Central Bank (ECB) which is unlikely to generate a meaningful impact on the euro next week.

“Although the pace of currency appreciation has not been alarming, the ECB is very likely to be unhappy with the stronger EUR,” says Marco Valli, Chief Eurozone Economist at UniCredit in Milan. “However, there is not much the central bank can do about it, at least for now.”

The EUR-USD rate has risen by 2.3% since the previous ECB meeting (3.6% year-to-date).

However, the ECB will unlikely deliver an aggressive stance on the currency based on the observation that the Trade Weighted exchange rate has only risen 1.0% since the meeting and 1.9% year-to-date.

Therefore, the ECB will likely continue its tricky balancing act by, on the one hand, reaffirming in the introductory statement that rates can go lower if needed, and, on the other hand, acknowledging in the Q&A that the downside on rates is not unlimited.

From the account of the 10 March meeting, we got the impression that the bar for another rate cut is fairly high because the effective lower bound – as currently perceived by the Governing Council – may only be some 10-15bp away.

“Down the road, in case the ECB regards further stimulus as warranted, additional asset purchases would be more likely than another rate cut,” says Valli.

UniCredit expect appreciating pressure to remain but see limited upside as EUR-USD undervaluation is no longer extreme.

Indeed, analysts believe the shared currency is approaching fair value against the dollar.

Why the Dollar is Looking Shaky

The U.S. dollar traded lower against all of the major currencies at the close of the preceeding week thanks to mostly softer U.S. data. 

Although manufacturing activity in the NY region expanded at its fastest pace in more than a year, industrial production contracted sharply and consumer sentiment hit its lowest level in 7 months.

Americans are concerned about the upcoming election, wage growth and household finances, which may explain why spending has been so weak. 

Outside of a few upside surprises, most of this week's U.S. economic reports highlight the ongoing challenges in the U.S. economy. 

"Not only will the Federal Reserve refrain from raising interest rates in 2 weeks but the FOMC statement could contain slight downgrades to their assessment of the economy.  We expect the dollar to resume its slide in the days and weeks ahead.  USD/JPY is looking particularly vulnerable as more earthquakes hit the south of Japan and tsunami warning has been issued," says Kathy Lien, Director at BK Asset Management