How much trouble is the dollar in, particularly against the euro?
The buck has certainly taken a fresh hit since the Fed yesterday declined to give a note of sufficient hawkishness to propel it higher. The changes to the central bank’s language were tiny, but the market has clearly got the message. The euro is (just) above $1.17, sterling is at its highest since September last year at $1.3140, and the dollar index, as you can see from the chart above, is wilting.
Kit Juckes at Société Générale thinks Fed balance sheet reduction will do less to boost the buck than ECB tapering will for the euro. He writes:
The danger is that we have a typical summer overshoot. By the time the ECB meets again, they may well find a euro is worth $1.20, which really won’t help their inflation forecast at all. That will, in turn, complicate the path of policy and at some point, we’ll get an FX response.
The path from $1.20 towards the Big Mac fair value of 1.25, let alone the OECD PPP fair value at $1.33, won’t be in a straight line. But I mention those only to make the point that an economic bloc with a huge current account surplus can’t have both monetary policy normalisation and an undervalued currency.
Lee Hardman at MUFG also thinks this could gather momentum quickly:
The scale of the US dollar sell-off has been reinforced by the proximity of important technical support levels which have been broken.
The euro’s rise to its highest levels against the US dollar since the run up to the ECB’s decision to begin QE, will attract the most attention and provides a further signal that the US dollar bear market is likely to extend further, heading into year-end.
There is a building risk of a more abrupt adjustment lower for the US dollar, which could soon lift the euro back above the $1.20-level.
And Alan Ruskin at Deutsche Bank says there’s no reason for the gap between eurozone and US interest rates to hold this back, noting: “How far can EUR/USD stray from rate spreads? Far.” He adds:
The FX market is prepared to trade the key euro pair, one level at a time. If the 2015 high at 1.1714 goes, then test the 2010 low at 1.1877, and if that goes on to the 1.20 round number. A move beyond the 1.2042 the 2012 low is regarded as very unlikely as it would represent an unusually wide disconnect with key rate spreads.
A very relevant follow-up question is: how disconnected is [the spot rate] with rate spreads, and how unusual is it to disconnect? The short answer is less unusual than commonly thought, suggesting rate spreads are less of a top side constraint to the euro’s progress.
While it is still expected that a combination of; i) a euro return to long-term fair value; ii) the ECB’s subtle attempts to discourage euro appreciation; iii) positioning, and iv) rate spread models, should reinforce the top-side resistance at the 2012 low of 1.2042, rate spreads have in the past not stopped bigger overshoots than 1.20+ would represent.