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The current discouraging blend of political uncertainty and receding interest rate expectations in the US have contributed to the dollar’s sell-off. The euro area’s financial conditions remain very accommodative, suggesting the recent rise in the euro won’t choke the recovery. Further gains in EUR/USD look plausible, although there are likely to be limited to the ECB’s tolerance for a stronger euro.
Having moved in a broad 1.05-1.15 trading range for the best part of the past two and a half years, EUR/USD is currently breaking to the topside. Now that a move towards the top end of the established trading range around 1.15 has been achieved, the question now is if a more sustained and durable trend in EUR/USD is emerging or whether EUR/USD is moving into a higher trading range.
The ECB is by no means embarking on a similarly aggressive tightening: inflation is still substantially below trend, especially core inflation, and the central bank continuously emphasises that a substantial degree of monetary accommodation is still required.
The ECB’s rule of thumb is that every permanent 10 percent appreciation in the exchange rate reduces inflation by 0.4-0.5 percent. In 2016, the EUR/USD averaged 1.11. So far this year it has averaged 1.09, so the exchange rate at current levels is not currently posing an issue. However, if it were to average 1.20 over the next year, that would put downward pressure on inflation. The ECB forecasts that inflation will be 1.3 percent next year based on an average EUR/USD exchange rate of 1.09.
"On this basis, there may be limits of tolerance to extended euro appreciation and we would not be surprised to see some resistance emerge should EUR/USD meaningfully breach 1.20," ANZ Research commented in its latest report.
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