How far can the euro go?

Euro strength was a surprising feature of 2017, and as the currency hits fresh highs against the US dollar, it looks like the trend is not going away.

European Central Bank
Source: Bloomberg

‘Euro to reach parity with the US dollar in 2017’. Remember this call from Goldman Sachs a year ago? Since then the single European currency, as I still quaintly call it, has appreciated by 15%. This illustrates nicely the difficulty of making forecasts.

But the question must be asked, how much more can the euro rise? And, indeed, why does it continue to rise?

We will answer the second question first. Since the beginning of 2015, we have seen a steady recovery in eurozone economic data, which points towards sustained improvement for the bloc. Gross domestic product (GDP) growth has risen markedly, from 1.5% year-on-year (YoY) in the fourth quarter (Q4) of 2014, to 2.6% in Q3 of 2017. The unemployment rate has fallen from over 11% at the beginning of 2015 to below 9% two years later. The composite purchasing managers index (PMI), which tracks business trends across manufacturing and services, has risen from 52 in January 2015 to 58 by the end of 2017.

This procession of good news has driven a surge in demand for eurozone stocks. Data from Bank of America Merrill Lynch, in the form of their monthly fund manager survey, consistently pointed throughout 2017 to eurozone markets being some of the most popular trades. Investors, buying euros in order to buy eurozone stocks, drove the currency higher, as they sought exposure to this strong economic recovery. Thus, we witnessed the remarkable spectacle of investors causing the euro to rise, driving down eurozone stocks during the latter half of 2017, even as the European Central Bank (ECB) proceeded with €60 billion a month in bond purchases as part of its quantitative easing (QE) programme.

Now, the picture on that front is changing. Already, the ECB has scaled back purchases to €30 billion a month, as the stronger economy reduces the need for ultra-loose monetary policy. The question is now turning to whether the ECB will scale back QE further, and even when it might exit from its policy of negative interest rates.

Traditionally, an end to QE and higher rates (‘tighter monetary policy’) tends to drive an appreciation in the currency, as investors look to take advantage of the higher yields on offer. Thus, it is reasonable to think that the euro’s rise will continue as the ECB shifts towards tighter policy. One possible fly in the ointment is that the higher euro will cause imported inflation to fall, reducing the need to raise rates. While some tighter policy may be appropriate, the path to higher rates may be a very slow and gradual one, as slow as, or even slower than, the Federal Reserve’s (Fed) recent hiking path.

Let’s return to the first question, regarding how much further the euro can rise. EUR/USD, the currency pair itself, hit a high over $1.60 in 2008, but since then it has fallen by almost a quarter. The weekly chart offers perhaps the best view here. We have seen the price break through the $1.2092 high from 2017, and now it is pressing onwards towards the November 2012 low at $1.2661. A pullback in September and October found support at $1.1616, and any dip that stays above this constitutes another higher low.

It is worth noting the downtrend line from the 2008 high – this was tested in May 2014, when the 2012-2014 rally formed a peak at $1.1393. Another test of this downtrend line would likely come into play around $1.25.

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