BofA updates Euro-Dollar forecastsSees little chance of a major recoveryAs ECB struggles to raise interest ratesAnd deal with Eurozone fragmentation risks

Above: ECB President Christine Lagarde at the ECB's Forum on Central Banking in Sintra, Portugal. Photo by Sérgio Garcia, copyright: ECB.

The Euro will struggle to gain traction through the remainder of 2022 as the European Central Bank struggles to come up with the required tools to contain peripheral spreads as it seeks to raise interest rates.

This is according to Bank of America Merrill Lynch Global Research who have issued their currency predictions for the remainder of the year.

"The dovish ECB and the periphery keep the EUR weak," says Athanasios Vamvakidis, Global Head of Foreign Exchange Strategy at Bank of America Merrill Lynch.

The European Central Bank (ECB) is at the heart of the Euro's inability to make a sustained recovery says the analyst as it will struggle to keep up with its major peers when it comes to raising interest rates and reversing quantitative easing.

This confirms that for Bank of America the divergence in policy between major central banks will be a key driver of FX over coming months.

The analyst notes the ECB is left standing with the lowest policy rate in G10 and while most are starting a programme of quantitative tightening (the reversal of quantitative easing) the ECB is only now about to end quantitative easing.

He says the ECB will not start quantitive tightening until at least the end of 2024, and has pre-announced a July rate hike of only 25 basis points.

"We believe that the ECB is likely to remain dovish vs. most of the rest of G10, until they address fragmentation risks," says Vamvakidis.

Fragmentation refers to the divide that exists between Eurozone countries that have a better fiscal standing than others.

When the ECB raises interest rates it would inevitably see the yield weaker countries pay on their debt (bonds) rise faster than those of 'fiscally strong' countries such as Germany and France.

Foreign exchange markets will therefore arguably remain more interested in how the ECB deals with the question of keeping a lid on Italian and Greek bond yields than anything else it does.

Failure to address the issue could destabilise the Eurozone and is therefore a key risk to the Euro's outlook.

However the ECB said at its June policy update it has the tools to ensure the difference in bond yields between various countries remains stable, thereby containing risks.

The message was repeated by ECB President Christine Lagarde in her address to the ECB's Forum on Central Bank in Sintra, Portugal.

Above: The market's implied expectations for the amount of ECB rate hikes to come have fallen of late. Image courtesy of Goldman Sachs.

Reuters meanwhile quotes ECB sources at Sintra as saying there is a plan in the offing that will see the ECB continue to purchase bonds of vulnerable countries, which would cap the yield these bonds pay and therefore place a cap on top of borrowing costs.

But to offset this stimulus the ECB would drain liquidity from elsewhere in the system, potentially offering banks attractive interest rates to park cash at the ECB according to Reuters.

This is known as a 'sterilisation' programme.

But Vamvakidis says, "promising to design a new policy tool to address fragmentation risks means they don’t have one yet."

Bank of America's mid-year forecasts for the Euro to Dollar exchange rate envisage ongoing weakness this year, but a gradual move back to equilibrium is anticipated long-term.

"We keep our EURUSD forecast for this year at 1.05, still below the consensus forecast of 1.10," says Vamvakidis.

For next year, Bank of America keep their forecast at 1.15, going to 1.20 in 2024.

"Our assumption is that FX moves back to equilibrium in the long-term, which in the case of EURUSD is between 1.20-1.25. However, uncertainty remains high beyond this year," says Vamvakidis.