FX: Time for a little caution on the euro

The dollar has found a little support this week, helped by Fed confidence that the economy and inflation are moving in the right direction. This theme may extend for a few more days given that later today we’ll see the Fed release its semi-annual Monetary Policy Report ahead of Jerome Powell’s first testimony as Fed Chair to Congress next Wednesday. Unless the Fed starts drastically revising its long-term neutral interest rate, however, it’s hard to see this theme driving the dollar much higher (short-term USD rates 10 years forward are close to the Fed’s current long-term rate of 2.75%). Instead, we expect investors and corporates to use any 2-3% correction higher in the dollar to position for multi-year dollar weakness as the US business cycle moves into its later stages. The US dollar index breaking above 90.56 would warn that the USD correction has further to run.

March 4th is a big day for European politics. We’ll see both an Italian election and also German SPD members voting on whether they support the proposed CDU:SPD coalition. Our team think the latter risk is under-priced, with a 40-50% chance the coalition deal is rejected. There is a scenario that sees Chancellor Angela Merkel stepping down. After a very good run for the EUR, this event risk could see a further scaling back of EUR long positions and a break of 1.2260 in EUR/USD could warn of a sharpish move towards the 1.2100 area. Caution is advised.

Minutes will today be released of the Feb 14th Riksbank meeting. Our interpretation at the time was that the Riksbank was pushing back the expected first hike from summer 2018 (we look for a hike in 4Q18), but dissent was brewing as Dep Gov Henry Ohlsson voted for a hike. Since then we’ve seen soft CPI data and the market struggles to price in 20bp of tightening by end year. While SEK is undoubtedly cheap at 10/EUR, it doesn’t look like today’s minutes will turn the trend of a weak SEK around.

S&P and Fitch provide a ratings update on Russia’s sovereign rating today. As Dmitry Polevoy notes, both agencies have Russia on a positive outlook, with any upgrade from S&P today taking Russia back into investment grade territory. Russia's 5-year CDS is already trading very tight at around 110bp – warning of a set-back to OFZs and the Ruble if both rating agencies merely retain their ‘positive’ outlook. However, we think there’s a chance that they make a move today and when combined with firming crude and reports of large Ruble tax payments due Monday, EUR/RUB could correct under 69.