Potential for ECB Surprise Boosts Euro's Appeal

While the dollar could strengthen on expectations of more U.S. economic growth and tighter monetary policy, the euro zone is approaching escape velocity.

The euro is in demand.

Photographer: Chris Ratcliffe/Bloomberg

It's about to get a lot more interesting for the dollar and the euro, with both the Federal Reserve and European Central Bank scheduled to meet next week. Expectations are high that the Fed will raise interest rates for the third time this year, while the ECB will keep its main rate at zero, where it's been since early 2016. But that doesn't mean the dollar is poised to outperform as the euro lags behind.

The dollar has had a tough year, mostly weakening since the end of 2016 before briefly rebounding in September and October. Now, it's back under pressure as the reality of additional deficit spending as a condition sine qua non for tax cuts becomes evident. The technical trading picture doesn't look good for the dollar either, even if Fed policy is likely to be more aggressive in 2018 than it was in 2017.

We have been expecting the Fed to boost rates in December since July. Traders put the odds of a rate hike next week at almost 100 percent, according to data compiled by Bloomberg. And make no mistake -- with the near complete implementation of tax cuts, more Fed rate increases are coming. Next week, the U.S. central bank will also provide updated forecasts for economic growth and interest rates, and those are likely to reflect the potential for more aggressive policy action in 2018 and 2019 than was forecast in September. That is likely to give the dollar a jolt even if the Fed hikes rates by only 25 basis points, as expected.

As for the euro zone, the economy is on fire. The German Ifo index, which is a critical measure of business sentiment in the nation, continues to hit new record highs. Plus, the euro zone manufacturing PMI has been on a tear, expanding for 53 consecutive months through November 2017, when it hit its highest level since April 2000.

While the dollar could strengthen on expectations of more U.S. economic growth and tighter monetary policy, the euro zone is approaching escape velocity. A surprise is coming from the ECB one of these months. If it doesn't come next week, the euro could come under pressure ahead of the Dec. 21 Catalan elections. That story hasn't fully played out, merely fading into the background. But don't be fooled by the reemergence of Catalan nationalism: Europe is the strongest it’s been since the beginning of the new millennium -- and the ECB will ultimately tighten up policy.

Trading patterns also convey a favorable outlook for the euro. Even after the passage of Senate tax legislation late last week, the greenback has remained below the critical 100-day moving average. In fact, the dollar is below most critical technical levels, with the last U.S. Dollar Index support at 92.6. This malaise in dollar trading technicals is in stark contrast to the euro, which has failed to close below $1.1607 based on CME's Globex electronic trading platform, a level which I referenced as critical in a recent Bloomberg Prophets commentary.

In the battle between the world's two most traded currencies, December could be a choppy month, but the euro is likely to emerge the winner in 2018.

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