Don’t write off the European Central Bank

Don’t write off the European Central Bank

While neutral on the euro in the short term, ECB tightening and a credible ‘anti-fragmentation’ tool could help the single currency stage a comeback.

The euro has recently come close to multi-year lows, reflecting increasing Fed rates, concerns about highly indebted European countries and rising energy prices. We remain neutral on the euro in the short term but are more constructive in the medium term as we are of the view that the European Central Bank (ECB) will deliver a significant amount of rate hikes by the end of the year and that market fragmentation risks will be quelled.

we think it is more likely that rates will fail to meet market expectations in the US than in the euro area by the end of this year, contributing to a narrowing of interest rate and growth differentials and favouring the euro relative to the overvalued US dollar. Furthermore, the end to negative interest rates and a credible mechanism to prevent market fragmentation could lead to significant improvement in net capital inflows into European debt securities. While we acknowledge that a marked slowdown in developed economies may keep the US dollar strong, expectations for rate cuts next year in the US could weigh on the greenback, especially if they support global risk appetite.

Admittedly, increasing geopolitical uncertainties could keep energy prices high and thus weigh further on the euro versus the US dollar in the short term and the credibility of ECB plans to tackle market fragmentation may be tested. But we think the ECB’s scheme will prove robust and serve to quell concerns rapidly. Consequently, we remain neutral on the euro in the short term, with a three-month projection of USD1.06 per euro (with risk biased to the downside prior to the ECB’s July meeting and to the upside afterwards). At this stage, we see limited reasons to change our more positive six-and 12-month projections (USD1.11 and USD1.15, respectively).

The main risk to our constructive view on the euro comes from a sustained rise in gas prices and challenges to building gas inventory ahead of winter. Other important risks are failure by the ECB to deliver on a credible ‘anti-fragmentation’ tool and persistent US inflation that induces the Fed to remain focused primarily on its price-stability mandate.

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