The EUR/USD Top

The USD has turned around, completing its downward correction within a secular bull trend

ECB keeps transmission channels open. Risk appetite remains the key variable for judging the EUR. The EUR’s funding status suggests repatriation related inflows will occur when investors reduce risk exposure, while rallying equity markets would push the EUR lower. The ECB is primarily relying on two transmission channels for its nonstandard monetary policy measures, we believe: i) higher portfolio valuations potentially unleashing demand via wealth effects, and ii) a lower EUR shifting relative competitiveness in favour of the eurozone.

The ECB, the EUR and risk. High bond market volatility can block these channels by weakening the outlook for risky assets, while simultaneously pushing the EUR higher. At this stage the EMU economic recovery seems too fragile for the ECB to allow monetary transmission to weaken. Hence, we would expect the bank to verbally intervene whenever it feels it has to unlock these channels. This weekend’s ECB Forum provides a platform to communicate with markets.

Positioning for US rebound. Otherwise, it will be potential US data strength that steers the outlook for the USD. In our overview section we revisit and adjust our FX framework. A country’s position within the global debt cycle, its relative output gap and the related inflation outlook should drive capital flows and hence FX valuations. Our analysis indicates both the USD and GBP are in a strong position. EUR weakness should be steered by the ECB and its attempt to keep monetary transmission intact. We stay generally bearish on EM with INR and CEE the exceptions.

FX rebalancing risks. Some currencies in Latam, such as COP, look vulnerable, due to a lack of trade rebalancing, even after stripping out the impact of commodities. CLP and MXN show the most bullish dynamics. Weak domestic demand could put pressure on some AxJ currencies such as THB and KRW.

What we trade?

We increase our bullish USD exposure and buy USDJPY as we identify this trade as the cleanest way to participate in USD strength in the short term. We recommend being short EUR/GBP and CAD/MXN.

Morgan Stanley Research – Global Currency Research Team