Where now for the euro?

Are we entering the last phase of the euro rally? EURUSD seems to be getting altitude sickness above $1.20 but is this just a consolidation phase before another push higher, or has the rally run its course?

EURUSD pared gains in the morning session, failing to hold onto the $1.20 handle to trade around $1.1950 having hit its highest level since January 2015 yesterday. To a certain extent this is something of a risk-on move that we are seeing elsewhere in the markets today. EUR has become a safer harbour (a new haven?) and enjoyed a flight to quality yesterday that may be seen as part of the broader risk-off moves, and so a touch of selling has to be considered in context of a slightly stronger US dollar as risk returns to the markets today.

There are several reasons to think the euro’s rally could carry on, with inflation and growth looking exceedingly promising. However there are also reasons to think it may be coming to an end.

Growth

Moody’s has upgraded its growth forecast for the Eurozone and expects “above potential” growth in 2017 and 2018 for the bloc. Germany’s growth was upgraded to 2.2% this year and 2% in 2018. France and Italy’s economies are also expecting to expand faster than previously thought.

Meanwhile Moody’s says US growth will be just 2.2% this year, from a previous estimate of 2.4%. Next year’s forecast was also cut from 2.5% to 2.3%.

Certainly the outlook for growth in the Eurozone is showing an improving trend while in the US is in reverse as the promise of Trump’s reforms fades. PMIs have also painted a picture of improving growth in the Eurozone that indicates it is more resilient than at any time since the financial crisis – conditions that would certainly justify a reduction in ECB stimulus.

Inflation

Eurozone inflation is likely to be solid after German regional data showed decent price growth. Inflation in Brandenburg was 1.8%, from 1.4% in July, while Hesse was also at 1.8% from 1.9% last month. Bavaria rose to 1.8% from 1.6%. Saxony saw annual inflation of 1.9%. Meanwhile Spain recorded 2% inflation. Euro strength could crimp inflation but the trend is improving and gives the ECB ammunition to taper.

Confidence at 10-year high

And confidence is soaring in another bullish signal for the euro. Economic confidence in the Eurozone hit its highest level since July 2007 in a sign that businesses and consumers alike are bought into the recovery now. This could be the unshackling that the ECB needs for the recovery to be deemed sustainable without QE etc.

ECB meeting in focus

Next week’s ECB meeting clearly has added significance for the EUR. We have markets expecting tapering to be talked about but there is a real chance that Mario Draghi may disappoint given his preference for caution and having been burned twice before tightening too quickly.  However, this time looks different for the Eurozone: the data is starting to converge into goldilocks territory with growth powering on, inflation ticking higher towards target and confidence high.

Speculative running out of steam

Buying pressure could be on the wane with net long speculative positions drying up. EUR went from net short to net long back in May and but there are signs this is running out of steam and the trend could be set for a reversal.  The risk for the longs is that the rally has been a buy-the-rumour trend front-running an expected ECB taper that has been forecast for the autumn for months now. There is a chance for disappointment with expectations for tapering now extremely high and exhaustion setting in among the bulls.

Key test for Macron coming up

The big shift for the euro happened in May after Emmanuel Macron’s victory effectively killed off the existential threat to the single currency that a Le Pen victory might have heralded. With political risk off the table for now it’s been a green light to buy the euro.

So Thursday’s labour reforms announcement from Mr Macron is a key test of strength. Unions are keeping their cards close to their chests but there is a chance that either the reforms don’t go nearly far enough for markets, or are too harsh and put the president on a collision course with workers.

This is the big test for Macron. His approval rating has sunk – a recent poll said 57% are dissatisfied with him and the prospect of a run-in with unions so early will be pivotal. It seems hard to imagine a Thatcher-like victory heralding a new era of economic liberalism.

As noted in May, with a third of voters backing Le Pen and abstentions highs, there was never universal adoration for the ex-banker. His time in the economy ministry was notable for timid reforms. A personal mandate this time might be different but it’s going to be tough to energise France’s sclerotic economy.  There is now considerable risk that Macron will disappoint and this might raise political risks again.

Trump tax reform – still kicking?

Meanwhile today we are expecting more on Trump’s tax reforms. If these do what they intend it could jolt the dollar out of its malaise. However as with previous Trump reform promises there is some scepticism. It’s expected to be a speech light on detail so it’s hard to see this doing much for the dollar for now except keeping hopes alive for the time being.

But should we even call them Trump’s tax reforms? The GOP is in the driving seat with these as the writing of the legislation has been turned over to congressional committees and will not be White House led. This is important as it makes the chances of a coherent set of legislation that will pass Congress a lot more likely, however it reduces the chances of a big bang set of reforms that unleashes the growth potential expected when markets rallied on Trump’s election.

The Fed

The Fed is also in action this month and the big question is balance sheet reduction. Market participants appear split over the extent to which this will impact markets. Taking a simplistic view, if QE was good for stocks then unwinding it will be bad. Treasury yields should rise and the dollar with them. The market may be underestimating the potential for a dollar bounce on the expected reduction of the balance sheet. This is probably the biggest unknown facing EURUSD at present.

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