Too early to turn negative on the USD

A fundamental change in fiscal policy in Europe

The dominating themes for markets have been the underperformance of US assets and the fundamental shift in fiscal policy in Germany with a reform of the constitutionally enshrined debt brake set to increase infrastructure and defense spending. Long-end German yields have increased sharply with the outlook of more issuance and improved growth prospects for the German economy. The ECB has sent tentative signs of its reaction function changing, highlighting that it increasingly sees the risk to inflation skewed to the topside. US recession fears have resurged with a softening of business sentiment, weakness in consumer confidence and weak retail sales weighing on growth prospects. These risks are further exacerbated by elevated uncertainty regarding tariff policy from President Trump. Geopolitical uncertainty remains elevated with impending Russia/Ukraine-peace talks.

Over the past month, the EUR has experienced broad-based strength on the back of a fundamental change to fiscal spending in the euro area set to improve the growth backdrop the coming years, which has favoured European equities. This has pushed EUR/USD above the 1.08 mark and favoured cyclically sensitive currencies. SEK has continued its move higher aided by topside inflation surprises and the Riksbank likely now having reached the end of its cutting cycle. NOK has benefited from the weaker USD, the change of flows back to Europe and higher Norwegian rates, sending EUR/NOK below the 11.50 mark.

Outlook: Positive on the USD and negative on Scandies

We maintain a negative medium-term outlook for EUR/USD, targeting a decline toward 1.06 over a 12M horizon. We raise the profile as the shift in risk asset allocation away from the US appears structural. Longer term, the need for contractionary monetary conditions amid US growth keeping up, and supported by EU fiscal policy shifts, support the notion of elevated real rates and a strong USD. We remain medium- to long-term negative on NOK due to long-run NOK real rates, the relative attractiveness of the Norwegian asset market, the balance of risk for energy prices, relative unit labour costs and the continued headwinds stemming from elevated global real rates and a strong USD. The medium-term headwind for the broad SEK remains intact and we expect EUR/SEK to rise to 11.30 over the next 12 months.

Risks to our forecasts primarily lie in a sharp economic downturn and a resurge in inflation. A hard landing would require sharp easing of global monetary conditions, which would likely entail a much weaker USD (after an initial squeeze higher) and much weaker cyclically sensitive currencies than in our base case. Another risk is the broad-based EUR optimism materialising creating a more lasting narrowing of structural growth differentials to the US.

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