The thinking behind our EUR/$ forecast: When we last changed our FX forecasts in early December, we set our 3-month forecast in line with the spot rate at the time at 1.33. However, linked to the view of our European economists that the crisis will deepen initially before the situation improves, we signalled downside risks, potentially substantial, in the near term before bouncing back to the 3-month target. In terms of timing, the EUR/$ forecast path assumed that the Italian funding hump in February is the key event to watch and therefore the broad design of a comprehensive European policy response would become apparent during 1Q. Beyond that point, the gradual relaxation in Eurozone risk premia would then translate into better performance more broadly of risky assets. Given strong cross-asset correlations – and a risk premium in the EUR itself – this then would also be expected to help the Euro recover. Underlying broader USD weakness would help this move towards 1.45, our 12-month forecast. In that respect it is worth keeping in mind that, relative to the US, the Eurozone actually does address structural fiscal issues.
How are we doing with this forecast: So far, things have not deviated too much. There is some intensification in Eurozone fiscal concerns visible currently and the December summit left important issues unresolved, in particular on the enforcement side of better fiscal policy coordination in the Euro area. Italian bond yields and the trade-weighted EUR have duly responded, with the latter having lost about 3% since early December. The whole idea of markets forcing policymakers into action in our view means it is very likely that these trends will continue in the short term.
Macro changes we did not fully anticipate: Beyond the simple rise in risk premia, there have also been developments that suggest more broadly a downward shift in the expected EUR/$ trajectory. US growth has been more resilient and the ECB liquidity injection more forceful than thought in early December. At the margin, this has shifted the growth/monetary fiscal mix towards a deeper trough and a somewhat weaker subsequent rebound in EUR/$. Moreover, we see a risk of further substantial ECB balance sheet expansion in addition to the one already seen.
About the difficulties of forecasting a market-dependent policy move. A considerable complication when forecasting in the current environment is that we know we would look wrong at some point even if spot perfectly followed the expected trajectory. This is because a majority of market participants have to believe in a Eurozone blow-up, push asset prices lower and therefore trigger a policy response. We have seen this dynamic at work before and the difficulties of translating a market-conditional worse-before-it-gets-better view into a sensible forecast path.
How much lower how quickly? With considerable downside risk in the short term, within our regular 3-month forecasting horizon, the key questions are about the speed and magnitude of the initial sell-off. If we had to publish forecasts on a 1- and 2-month horizon, we could see EUR/$ reach 1.20. In other words, we expect the EUR/$ sell-off to continue for now as risk premia have to rise initially.
1.20 to 1.45 in less than a year? Inserted into our regular forecasts, such a gloomy short-term scenario would also imply a very substantial and steep rally later in the year. We are less sure about that assumption than we were, though the notion that EUR/$ rallies by 25 big figures in less than a year is more common than some often assume. In fact, we have seen quite a few similar moves in recent years, as the table below shows, and typically they have occurred faster than the recovery we currently project. On the other hand, as mentioned above, the marginal macro news on either side of the Atlantic suggests that the expected rebound may not necessarily live up to the more extreme scenarios of the recent past. In that respect, the risks to our current 6- and 12-month forecasts appear skewed toward a less extreme move this time.
Uncertainties about timing. One obvious risk is the exact timing when the point of deepest despair is reached. The Italian bond rollover in February is one obvious point, as mentioned above. But if the Italian government issues mainly short-dated bonds, the funding hump may actually be less of a challenge, in particular with ample ECB liquidity supply. The Greek PSI debate (March) or French elections (April/May) are other potential trigger events, well beyond the 1- or 2-month horizon. There is clearly a risk scenario where a comprehensive policy response may only become visible by the middle of the year. This would imply some clear downside risks to our 3-month forecasts as well and a delayed start to the subsequent Euro recovery. But things could be worse still, with our European economists arguing that an eventual break-up cannot be ruled out. All of this highlights the large uncertainties around any medium-term path when a wide range of outcomes is conceivable.