The latest FX Viewpoint from Bank of America / Merrill Lynch: Don't fight the central banks when they want to do the right thing

  • Markets wrong about Fed and ECB. Policy surprises to weaken EUR/USD by year-end.
  • EUR/USD has overshot data. Quant and technicals point to downside risks.
  • We recommend shorting EUR/USD, target 1.15, stop loss 1.21, spot reference 1.1891.

*Don't fight the central banks
Markets have been fighting the major central banks and we argue that they will be proven wrong, leading to lower EUR/USD in the months ahead following the recent rally.

*Markets expect too little from the Fed
The consensus is that the Fed will focus more on low inflation and stay on hold. We argue that the Fed will focus more on loose financial and monetary conditions, as well as risks to financial stability from asset price bubbles, and will continue normalizing policies gradually. We also argue that US inflation could start surprising to the upside.

*Markets expect too much from the ECB
The consensus is that ECB QE tapering is inevitable and that there is nothing the ECB can do to weaken the Euro. This suggests asymmetric risks from a dovish ECB. We expect very slow QE tapering and forward guidance linking rate hikes to inflation.

*Alternative scenarios and risks
We consider a good, a bad and an ugly scenario for the US and the global economy. The USD should do well in most scenarios, although one would have to be selective depending on the scenario. The USD could do particularly well against high beta currencies and EM FX, even in a good case scenario. All our scenarios also point to higher FX vol.

*Quant: medium-term bearish EUR/USD
EUR/USD gained from USD weakness in US hours as post-election trades were unwound earlier this year. However, year-to-date EUR has diverged from 2y rates spreads and our rates-based OCTAVE model is now bearish. In addition, our models suggest EUR longs are stretched, with Up-Down vol flagging reversal risks. However, EUR Residual put Skew has come off after Jackson Hole, and options are less bearish in the short term.

*Technicals: YTD rally and momentum set to correct
The market rejected EUR/USD > 1.20 after an intraday high of 1.2070. Price action, patterns and momentum suggest a tactical decline to the 1.17's. Bullish weekly momentum is an overbought anomaly with RSI at the third highest overbought reading since EUR/USD began. Past anomalies resulted in a 3.75-9.06% spot decline and so a momentum based correction could be deeper, such as the previously relevant 1.15 area. If EUR/USD ends on a high note in August, the monthly chart will show a bullish momentum breakout. However, if EUR/USD continues to slide, momentum may have peaked, favoring a larger spot decline. Breadth supports the EUR uptrend and agrees with the uptrends that follow momentum anomaly corrections.

*New trade: short EUR/USD spot
We go short EUR/USD, target 1.15, stop loss 1.21, spot reference 1.1891. Risks to this trade are the Fed not hiking again this year, the ECB announcing fast QE tapering and the Eurozone economy continuing to decouple from the US.


Plenty there from BoA/ML to mull ahead of today's NFP