Dollar continues to get booster from FED and Trump’s administration, Euro clouded with French and German polls, EUR/USD heading for parity

The Fed took less of a “wait and see” position on the effect of fiscal policy stimulus on the stance of monetary policy than we had anticipated. Fed Chair Yellen sees little need for large-scale fiscal stimulus when the economy is in the neighborhood of full employment and inflation is firming. As was widely expected, the FOMC raised the target range for the federal funds rate by 25bp to 50-75bp at its December meeting.

Although the road to the first round of the Presidential election (23 April) is still long, we believe Mr Fillon’s election as the Republicans’ candidate should provide the markets with some reassurance. Under our baseline scenario, we see a referendum on EU/euro membership as unlikely. Such a referendum remains highly dependent on the results of the general election.

Italy remained in the spotlight this week with a new government, mixed news about banking sector restructuring and risks of a referendum on past labor market reform.

Elsewhere, the upcoming German federal polls would elect the members of the Bundestag, the federal parliament of Germany in 2017, but the latest reactions to the violent Monday evening attack on a Berlin Christmas market that left 12 dead and 48 injured would be closely watched for their potential to affect next year's crucial elections in Germany.

While EURUSD still heading for parity, the 10y real yield differential between Germany and the US is out to 158bp today and has just come back from its widest level since index-linked bonds started trading. The 10y real yield differential has also just nudged through the wides we saw in early 2015, which coincided with the previous low for EURUSD in this cycle.

In nominal terms, the yield differential is wider than at any time since early 1989, when 10y Treasuries were around 9.25% and Bunds under 6.75%. But here, too, there are limits to how much further they can go. In 1990, they converged really fast. And among the things that don’t easily justify endless divergence, the recent convergence in nominal GDP growth between Europe and the US stands out.

The expectation of EURUSD to reach parity between now and the French elections in April/May, but we also expect the euro to be stronger in a year’s time than from the present scenario. Welcome and embrace the stance of the Fed hiking acceleration, and it’s also OK to embrace the idea of the US getting a growth boost from a Trump administration. But a lot of that is already in the price. EURUSD staying sustainably below parity still seems unlikely unless the elections in France throw up a major surprise.