EUR/USD Monthly Fundamental Forecast – August 2016

The EUR/USD soared in the last few days of the month as the greenback tumbled after the FOMC attitude change. The US dollar is down 2% for the month while the pair is at 1.1174 with a gain of 0.34%. The ECB held rates and policy at its July meeting but is expected to act in August, while the FOMC turned more hawkish as US data printed better than expected until the release of a disappointing GDP report on the last day of the month. Traders are increasing their odds of a rate increase this year again. The Federal Reserve will likely keep policy on hold this year, and slow the pace of interest rate normalization next year owing to the increased uncertainty and volatile financial market conditions in the aftermath of the U.K.’s Brexit vote. This uncertainty is already contributing to strong ‘safe-haven’ flows into the U.S. dollar, which will weigh on U.S. growth and inflation prospects.

Continuing gains in consumer spending and housing activity are helping to keep the U.S. on a moderate growth trajectory. Relatively buoyant increases in jobs and wages, combined with historically low interest rates and prices at the gasoline pumps, are underpinning the purchasing power of Americans.

After Eurozone inflation moved back into positive territory at 0.1% y/y in June, the Brexit vote has refueled concerns of deflationary risk in the Eurozone. Indeed, medium-term inflation expectations have moved lower, with the highly watched 5y in 5y inflation swap falling to a record low of 1.3%, well below the ECB’s inflation target of close to, but below, 2%. Despite this unwelcomed decline, we believe that the ECB will maintain a wait and see approach in order to assess the full impact of Brexit before unveiling further monetary stimulus. However, the ECB’s September meeting is an important one to watch as the ECB staff’s new macroeconomic projections will be released and should provide the first assessment of the potential downside risks to inflation.

It is worth highlighting that, before the U.K. referendum, the ECB was in the process of starting to revise its inflation forecasts upwards, albeit at a very modest pace. Indeed, the ECB’s inflation forecast in its latest quarterly macroeconomic projections report for June was revised up slightly to 0.2% y/y this year from 0.1% in March, while 2017 and 2018 were left unchanged at 1.3% and 1.6%, respectively. Looking ahead to September, the factors that we believe could facilitate further changes to these forecasts are broadly neutral.

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