1.20 area is likely to contain rallies in EUR/USD - Rabobank

"We maintain our view that the 1.20 area is likely to contain rallies in EUR/USD until the end of the year and that 1.25 is still achievable on a 12 mth view. However, political developments in both the Eurozone and the US pose risks to the uptrend in EUR/USD," notes Rabobank Senior FX Strategist Jane Foley.

Key quotes:

"The trigger for the sell-off in EUR/USD at the start of this week was the news of Chancellor Merkel’s hollow victory in the Germany election. Merkel may have won her fourth term in power but it was the far-right AfD’s success in becoming the third largest part in the Bundestag that stole the headlines. The implication is that the next few years could be tough for Merkel. Markets may also infer that the political backdrop in the Eurozone is still disjointed and continues to pose a threat to investment potential medium-term. The news followed a period of unusual political calm in the Eurozone which had added to the attraction of the EUR earlier in the year."

"Although Eurozone politics may yet have more populist and far-right bombshells to give, the region can still offer strong economic growth. The environment of strong growth and low interest rates is an attractive one for investment and should, in theory, offer continued support to the EUR. Expectations that the ECB will push ahead and taper its QE programme next year are also positive for the EUR going forward."

"As the market built long EUR positions this year, it simultaneously reduced its USD exposure. At the start of this week the USD was benefitting from short-covering as the market questioned whether this year’s dollar downtrend had extended too far. Not only has Fed Chair Yellen recently heightened market expectations regarding the chances of another rate rise in December, but US Republicans have finally outlined a tax plan to support their pledge of putting into law a key piece of fiscal reform this year. That said, the GOP’s tax plans have already hit a hurdle. In order to pay for the plan, various tax breaks will have to be repealed. One day after the tax initiative was announced, Republicans were debating scaling back one of their most controversial proposals regarding the trashing of the individual deduction for state and local taxes. Overall, there remains
widespread scepticism as to whether the Administration can push through a key legislative success before next year’s mid-term elections, never mind by the end of the year. Also, even if the Fed pushes ahead with a rate hike in December the subdued nature of inflation in the US suggests that the trajectory of policy tightening is likely to flatten. The release of the core PCE deflator, which is the Fed’s favoured measure of inflation, edged down to 1.3% y/y in August below July’s reading of 1.4% y/y."

"On balance, we are of the view that EUR/USD could be choppy around current levels on a 1 to 3 mth view. While we are forecasting a move to EUR/USD1.22 on a 6 mth view and to EUR/USD1.25 in 12 mth, a flare up in divisive European politics constitutes a risk to this outlook."