Article15 January 2018Reading time 4 minutes

EUR/USD close to 1.23 is still undervalued

Even after breaking yet another multi-year high, we see EUR/USD as still undervalued - by around 1-2% based on our short-term fair value model. This points to a benign outlook for the cross, with a fairly limited downside risk. Strong EUR translate into a sweet-spot for CEE currencies

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Fully justified move in EUR/USD higher

EUR/USD broke a new multi-year high, trading shy of the 1.2300 level. Was a such a move justified and in sync with fundamentals or is the EUR/USD rise overdone? We believe it is the former.

As per Figure 1, our short-term financial fair value model not only identifies the recent EUR/USD rise as justified (both the fair value and the spot increased) but in fact the EUR/USD still looks undervalued. The model-based EUR/USD cheapness looks to be worth between 1%-2% depending on the use of either swap rate or sovereign bond based model. This, in turn, translates into a EUR/USD short-term fair value of around 1.24-1.25.

EUR/USD is undervalued, even after the recent rise


Two “headline” and “underlying” drivers

While two “headline” news events triggered the recent push in EUR/USD higher (the more hawkish ECB Minutes and the tentative progress on the German coalition talks), based on our short-term fair value model two “underlying” drivers sent EUR/USD higher over the past weeks:

  1. The relative steepening of the German bund curve vs the UST curve (which, on the EUR side, should be attributable to the expectation of the end of the ECB QE rather than a premature ECB depo rate hikes);
  2. The benign risk environment, which is supporting EUR.

The importance of the latter for EUR is very clearly seen in Figure 2 which shows the beta of the risk factor to EUR/USD within our short-term model. Clearly, the sensitivity of EUR/USD to the risk environment has been rising meaningfully over the recent months, underlying the shift in investors’ attitude towards the common currency, with EUR turning into an investment currency.

EUR/USD sentitivity to risk rising


The journey towards EUR/USD 1.30 intact

The fact that the EUR/USD strength seems fully explained from a short-term fair value model perspective (in fact the model identifies the recent EUR/USD rise as muted compared to the levels suggested by the fair value) suggests that the fears of an overdone move in EUR/USD may not be justified. As per our FX 2018 Outlook, we embrace the strong EUR and expect EUR/USD to break the 1.30 level later this year as the market starts focusing on the second step of the ECB policy normalisation - the eventual deposit rate hikes. Note that the OECD estimate of the long-term PPP fair value is at EUR/USD 1.33.

CEE FX to key EM beneficiary from higher EUR/USD

In the EM FX world, the CEE currencies should be the key beneficiaries of a stronger EUR/USD. As per 2018 FX Outlook, the CEE FX is the only EM region that can neatly and directly benefit from a higher EUR/USD. This has been very much evident on the price action since last Thursday (when EUR/USD started rising), with all four CEE currencies (RON, HUF, PLN and CZK) being the top performers in the EM space (Fig 3). We expect this pattern to stretch further throughout 2018, with our top pick being lower USD/CZK. We expect the cross to test the 19.00 level by the end of 2018.

CEE FX benefits from stronger EUR/USD

ING, Bloomberg
ING, Bloomberg