EUR/USD: Draghi is not that powerful – Deutsche Bank

George Saravelos, Strategist at Deutsche Bank, tries to answer that what’s next for the euro now that their 1.20 EUR/USD target has been met so soon?

Key Quotes

“The ECB meeting is coming up next week and there are rising risks of verbal intervention from Mario Draghi. Despite this the euro level does not appear particularly extreme and most importantly the ECB has not been driving recent appreciation anyway. ECB verbal rhetoric may cause a correction but is unlikely to be enough to derail euro strength. We see the risks as still skewed towards the euro overshooting above 1.20 at some point this year rather than permanently reversing lower.”

“First, on technicals, we highlighted earlier in the year that the EUR/USD range was too narrow. The rally up to 1.20 brings the year’s EUR/USD range to 17 big figures, a little below the average since 2010. In other words, there is nothing “unusual” about the current size of the EUR/USD move compared to the last few years.”

“Second, on valuation grounds, EUR/USD is only just now approaching “fair value” on a number of our metrics. Our estimate of purchasing power parity (PPP) for the euro is 1.23. Our fundamental effective exchange rate (FEER) model which adjusts for the euro’s large current account surplus is 3% higher. The BEER model which adjusts PPP for productivity and terms of trade is a little lower. The same conclusions apply to the trade-weighted index, there is nothing unusual about the euro’s current valuations.”

“Third, on speculative positioning, while longs have been building, they are not particularly extreme. The aggregate non-commercial long on the CFTC is at the 90th percentile going back to 1999, but this does not account for rising trading volumes over time. Adjusting for open interest, longs are only at the 56th percentile, close to average since the euro’s inception. For hedge funds specifically the euro long is even lower at around the 40% percentile.”

“Fourth, on portfolio flows, the most important question for the euro is whether the structural underweight that has built up post-crisis has been adjusted. The IMF portfolio survey (CIPS) is the most comprehensive data source for this and as of last year it showed that American and European investors’ euro allocations were close to decade lows (chart 4). Reserve managers have been holding an underweight too. Even though this data is very lagged, the key observation is that it has taken a very long time to build the underweights and it will likely be difficult to cover in just a few months.”

“Taking it all together the 1.20 level in EUR/USD does not seem particularly extreme. The single biggest risk to EUR appreciation is its pace. With the tradeweighted having risen by more than 5% in just three months, this has typically driven verbal intervention by both Trichet and Draghi in the past. Despite this, verbal intervention may not be a game changer. First, everyone is now expecting it. Second, for verbal intervention to be credible the ECB will need to abort its QE exit plans for October.”

“Our economists do not believe EUR strength is large enough for this to happen. The current level of the euro would only require a 0.2% upward revision to European growth over the forecast horizon to maintain the ECB's inflation path. It is only at 1.25 or above where tapering would be aborted. Third, the Fed reaction function is just as important and it will be very difficult for the market to aggressively re-price the Fed in coming weeks, a phenomenon we have previously characterized as the zombification of the US hiking path. Finally, and most importantly, monetary policy is simply not the main driver of EUR appreciation. The market is becoming more structurally optimistic on Europe versus the US and the ECB may not be able to do much about it.”