Limited upside potential for the USD against the euro

The euro has plunged in value against the US dollar since the Fed’s meeting on 16 June, when its monetary stance turned less accommodative. The euro lost almost 8% from then until 24 November thanks to a sharp repricing of the Fed’s plans for rates – the market has started pricing more than two hikes by the end of next year.  By contrast, the European Central Bank (ECB) is nowhere near as close to hiking rates. As a result, monetary policy has turned significantly in favour of the US dollar relative to the euro.

That said, we continue to think that the other key driver of the EUR/USD rate over the medium term – the difference in economic growth between the two regions – should move in favour of the single currency at some stage in 2022. 

What’s more, the US dollar’s upside potential could be limited from here given the market has already discounted Fed rate hikes. One notes that concerns about the new Omicron covid variant saw the US dollar initially fall against major low-yielding currencies, suggesting that heightened covid worries may not fully support the safe-haven US dollar because they could affect the timing of the Fed’s first rate hike. We also expect the Fed’s monetary normalisation to be constrained by the volume of debt in the financial system. Beyond 2022, the Fed may find it difficult to maintain its restrictive stance, which could ultimately hurt the US dollar.

Longer term, the US dollar appears expensive based on classic valuation metrics. US’s twin deficits (current account and federal budget) also point to a weaker US dollar. Overall, while we acknowledge that the US dollar could continue to perform strongly in the coming months because of supportive monetary policy, we do not see any medium- or long-term factors that would justify a sustainable appreciation.

Based on the above considerations, we have modified our projections for the EUR/USD rate. Our three-month projection for the euro now stands at USD1.11 (from a current USD1.125), our six-month projection at USD1.10 and our 12-month projection at USD1.16.