Consensus was too bullish
For most of the year, EUR/USD has been quite bearish. We were initially concerned about the Fed’s front-loaded tightening cycle. Then we became more worried about the shock caused by Russia’s invasion. We had always believed that the dollar would peak this year, given that we believe that the Fed will likely cut rates in 2023.
Despite EUR/USD being at its lowest point of the year, we are bullish on EUR/USD with our end-of-year forecast of 1.08. We have had to be uncomfortable in presenting this view to our customers. Now we need to act.
The chart below shows, for reference, how consensus has struggled with this year’s sharp fall in EUR/USD.
With the EUR/USD drop, consensus struggles to keep up with it.
Valuation: The euro does not come cheap
While we understand that corporate treasurers often take FX sell-side forecasts with a lot of salt, the war’s terms and trade shocks and what they mean to EUR/USD fair values has been a negative development for the forecast profile. On 16 March we stated that EUR/USD was trading at 1.10 in real terms, and that it was not cheap.
Let’s now return to fair value. Our Behavioural Equrium Exchange Rate (BEER), model estimates the fair value of currency pairs in real terms based on medium term economic fundamentals. Terms of trade (the price for exports divided by imports), productivity and current account are all factors. The BEER fair value is calculated quarterly due to the frequency of these data.
A common observation across most G10 currencies is the fact that the terms and trade are the largest determinant of short-term swings of the exchange rate. This is especially relevant in this current environment where volatility in commodity prices has caused significant shocks to the terms of trade positions in many countries.
This terms of trade shock, especially for the euro, was caused by energy prices. The chart below shows the wide disparity between the prices that the US and Europe pay for natural gas prices. It was created by James Knightley, our US economist. In a recent article , our European sector and macro teams examined the full effect of gas shortages in the European economy. The dollar was always going to benefit from US energy independence.
Our EUR/USD BEER model, which has good explanatory power (R squared of 0.70), can show how the negative effect of the terms of trade shock (caused in part by high energy prices) on the equilibrium exchange rate has been significant. The chart below shows how each factor contributed to the changes in EUR/USD’s real medium-term fair values in each quarter. It is evident that the eurozone’s terms and trade have a dampening effect.
High energy prices have impacted eurozone terms and conditions of trade as well as EUR/USD fair values.
Despite recent weakness in EUR/USD spot (chart below), the decline in its BEER fair price caused by terms-of-trade effects was so substantial that we still believe the pair is around 5% overvalued relative to its medium term equilibrium level.
This does not mean that EUR/USD will trade consistently below parity over the medium-term. Deviations from the 1.5 standard deviation range can last for many quarters. However, it does show how the euro isn’t looking cheap when economic factors are considered. To “unlock” some of the material upside potential of the pair, it would be necessary to see an improvement of the terms of trade in the eurozone, or, in other words, an increase in energy prices.
Shifting the baseline situation
FX forecasts, as mentioned above, are not the only tool for corporate treasurers. We find it useful to present a scenario approach at ING. In June we presented four scenarios where our baseline (Scenario 2) showed EUR/USD remaining weak this summer but slowly rebounding to 1.08 at year-end, as investors’ attention shifted to the Fed easing cycle in 2023.
We are now more concerned about European growth prospects this winter because of the recent decrease in Russian gas supplies to Europe. As such, Scenario 3 seems like a more probable baseline scenario. For year-end, our EUR/USD forecast was becoming increasingly unfavorable.
Our EUR/USD forecast profile has been reduced in line with the Rate Strategy Team’s view of the eurozone/US swap spread divergence. This spread continues to move against EUR/USD through year-end with Fed expectations for easing only beginning to take effect in 1Q23.
This publication was prepared solely by ING for information purposes, regardless of the user’s financial situation or investment goals. This information is not intended to be an investment recommendation. It also does not include investment, tax, or legal advice. Continue reading.