Majors forecasts: EUR/USD to peak relatively soon as Fed could turn "hawkish"

13 January 2021

  Majors forecasts: EUR/USD
  to peak relatively soon as
  Fed could turn “hawkish”
Andreas Steno Larsen | Jan von Gerich

We see EURUSD peaking in the first half of 2021 as the USD yield curve is
still alive. The Fed could be tempted to “taper” formally already this year
and a hike in 2022 is clearly not out of the question. The ECB will remain
accommodative.
Highlights:

      •       Strong growth and inflation already during H1-2021
      •       EUR/USD could peak around 1.25-1.27 already during the first half of this year
      •       The USD curve has more steepening potential, while the potential is very modest
              in the EUR curve
      •       The Fed is not as dovish as anticipated and a taper process could be launched
              already this summer

Global: A growth “ketchup eect” and (headline) inflation upcoming
The manufacturing sector has already started to perform as a result of lagged eects of 2020 stimulus and
low interest rates. If we assume that we are only 4-6 weeks from the seasonal peak in the Covid 19 spread,
paired with a successful vaccine roll-out (news are increasingly upbeat), we will argue that most restrictions
on the service economy will be gone by mid-April or thereabout and momentum towards fewer restrictions
could already begin during March.

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Chart 1. Super strong nominal growth this year as a lagged eect om stimulus from 2020

This could lead to a benign economic scenario for the first half of this year with a strong re-opening
momentum in the service economy paired with a continued momentum in the interest rate sensitive
manufacturing sector. This could lead to a solid nominal growth pace in 2021 and we also see a possible
inflation pressure (mostly in the US) following it. Usually, long bond yields tend to pick-up when nominal
GDP growth is strong, but the USD curve should be (clearly) most sensitive to this storyline. EUR/USD could
consequently peak during the first half of this year because of a wider USD-EUR interest rates spread.

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Chart 2. Inflation pressure upcoming in the US?

FX: EURUSD to peak in the first half of 2021
We have warned in recent quarters about the risk of a much weaker USD alongside the rebound in the global
economy that would follow after the malaise in Q2-2020. The story has unfolded broadly speaking with a
weakening USD against EUR, EM and Scandis as we had anticipated. The consensus surrounding further USD
weakness is now striking and most, if not all, expect the USD to weaken further. There are sound arguments
behind such a view, most notably the massive double deficit of the United States, but it also seems as if
everyone is already positioned for the USD weakness, which could mean that the story is already mostly
baked in to market prices. In 2017/2018, EUR/USD rose towards 1.25 before reversing lower because of the
US once again outpacing the Euro area on growth and interest rates.

We are starting to see the contours of a similar develop in to the second half of 2021. A too strong EUR will
turn into a slight headache for European exports, while the US looks ripe for a solid economical comeback
meanwhile. We accordingly adjust our forecast to reflect this, and expect a peak in EURUSD during first half
of 2021 around the 1.25-1.27 area before a reversal longer alongside higher spreads between USD and EUR
interest rates.

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Chart 3. Could 2020/2021 turn into a mirror image of 2017/2018 in EURUSD?

Emerging markets countries have been on the receiving end of inflows after the Biden election victory and
due to positive vaccine news. We expect continued EM performance during the first half of this year, while
we also find that high-beta currencies such as Scandi FX, NZD and AUD will continue to perform against both
EUR and USD until a reversal of the USD trend occurs alongside higher USD interest rates.

GBP remains a tricky case and it is not carved in stone that GBP strengthens on the heels of a semi-lukewarm
Brexit deal. Trade in goods was secured on tari free terms, but trade will not be frictionless and the
whole service sector is still left partly in the dark. We see risks of a disappointing Q1 for GBP but do also
acknowledge that GBP looks cheap in a historical perspective.

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Chart 4. Which currencies gain from vaccine news?

We adjust SEK and NOK forecasts in a positive direction, while we expect EUR/USD to peak around 1.25-1.27
during the first half of 2021. The forecasts are presented below.

Table: New FX forecasts

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Fed: A hike in 2022 and a tapering process launched in summer 2021

The Fed is not as dovish as anticipated by many and there are already signs of a forthcoming discussion on
the QE pace. It will be interesting to see how the Fed tackles this discussion since a “taper-tantrum” needs
to be avoided. Various indicators hint of >2% PCE core price prints during the spring of 2021, which will
likely lead the markets to test the Fed AIT regime, since the Fed has not truly launched an AIT-regime in our
view. The first step for the Fed is to get rid of the promise to buy at a minimum pace in the QE program and
introduce flexibility along the lines that the ECB has done in the PEPP program.

Several FOMC members have hinted that they need to re-assess policy as soon as inflation has printed above
2% for some months in a row and even the über-dovish member Kashkari has explicitly written that he would
support a hike with 12 consecutive prints of 2% or more in core inflation. Currently no one is willing to talk
about the possibility of a rate hike already in 2022 from the Fed, but we find it likely that markets will at least
chase the story in to the summer of 2021 since the combo of high growth and increased inflation during Q2,
will push the Fed to debate the current policy mix. We add a rate hike from the Fed around mid-2022 to our
forecast profile and find that the Fed will start a formal tapering of asset purchases around summer 2021.

Chart 5. No one’s willing to bet on a Fed rate hike yet

ECB bond purchases to continue for longer but at a slower pace
The ECB delivered another sizable easing package in December, including a EUR 500bn expansion in the
Pandemic Emergency Purchase Programme (PEPP) and an extension in its duration to at least the end
of March 2022. We see a good chance that this was the last major expansion and extension in the

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programme. After all, the ECB has linked the programme to the coronavirus crisis phase, and we think it will
be hard to argue that the crisis phase is still ongoing in early 2022.

The end of net PEPP purchases does not mean the end of net purchases altogether. The Asset Purchase
Programme (APP) also continues at a monthly volume of EUR 20bn, and we expect the ECB to move
at least some of the flexibility of the PEPP into the APP later this year, when it concludes its strategy
review. The ECB could then continue net asset purchases also beyond March 2022, but the focus will
shift back to the APP.

Purchases will likely be sizable still in the first half of this year, when bond issuance needs are large, but the
peak pace of the purchases is likely already behind and the pace will gradually fall. The falling pace of
purchases will reflect the proceeding economic recovery but also a compromise between the more dovish and
hawkish members of the Governing Council, with the latter group actively reminding that the PEPP needs to
be only a temporary tool. Since the ECB has not set any purchase pace targets for the PEPP, it can allow
the pace to fall relatively silently without having to make an explicit decision at a monetary policy
meeting. This could make the ECB’s exit strategy somewhat easier.

The ECB as already taken a more flexible approach to its purchases. Rather than buying a specific amount of
bonds every month, the central bank will purchase flexibly according to market conditions and with a view to
preventing a tightening of financing conditions that is inconsistent with countering the downward impact of
the pandemic on the projected path of inflation. Preserving a tightening of financing conditions is probably a
relative concept, meaning the ECB would tolerate a gradual rise in longer bond yields, if they reflected a
rebounding economy and higher inflation expectations.

We do not expect the ECB’s policy to be on autopilot going forward. While no bigger decisions are probably
needed in the first meetings of the year, the terms of the Targeted Longer-Term Refinancing Operations
(TLTROs) will probably be eased further later this year, while the tiering multiplier could be raised.
Further, the ECB’s strategy review will be an important exercise, which should be concluded during the
second half of this year. We do not expect the ECB to cut its deposit rate further.

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Chart 6: Peak bond purchases already behind

Rates: US curve steepness to peak later this year
The notable economic recovery we expect to materialize later this year still leaves plenty of
steepening potential on yields curves, especially in the US, where the recovery is likely to be stronger and
the Fed quicker to make changes to its policies compared to the ECB. We expect the Fed to hike rates already
 in 2022, and curves normally start to flatten clearly before the first rate hike. As a result, we expect the US
curve to reach its peak steepness later this year and start to flatten next year.

We do not think the markets will be quick to price in any rapid or long-term Fed hiking cycle, and questions
about how high rates the economy can handle will probably increase, as longer rates continue to climb. As
a result, we do not see the US 10-year yield climb above 2% next year either, even if the Fed starts to
raise rates.

In the Euro area, any monetary policy normalization will be much farther away than in the US. The ECB
will continue its net bond purchases throughout our forecast horizon, but the pace of the purchases will
likely gradually recede and the ECB will tolerate slightly higher bond yields, as long the rise takes place
gradually and reflects and an improving economic and inflation outlook. We expect the German 10-year
yield to climb to zero by the end of next year, which still looks very depressed in a historical context.

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Chart 7. German yields not followed US ones higher lately

Our new forecasts for German benchmark yields

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Our new forecasts for US benchmark yields

Andreas Steno Larsen               Jan von Gerich
Chief Global FX/FI Strategist      Chief Analyst
andreas.steno.larsen@nordea.com    jan.vongerich@nordea.com
+45 55 46 72 29                    +358 9 5300 5191

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