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Citi cuts euro forecast on fears sovereign crisis could overwhelm authorities

Citigroup has lowered its medium-term (six- to 12-month) euro/US dollar forecast to $1.37 from 1.47 because of the increasing likelihood of a wider eurozone fiscal crisis and the growing resilience of the dollar. Longer-term, its target is largely unchanged at $1.38.

The peripheral European crisis has rumbled on for almost 18 months but the euro has proved remarkably resilient, assisted by the European Central Bank, which has sought to normalise interest rates and thus create a positive interest-rate differential versus the dollar. That strategy could well unravel, says Citi. With Italy, the world’s third-largest bond market, now being dragged into the spotlight, there are growing concerns that the European Financial Stability Facility and related resources will simply be overwhelmed, leaving the ECB as the lender of last resort. That’s seen further ECB rate increases priced out of the interest-rate futures markets but, as Citi notes, no one is yet brave enough to price in future interest-rate cuts.

“How can the ECB hike if Italy’s bond market is seriously under pressure? And if the ECB has to add liquidity, surely the longer-term outlook for the euro is also for weakness?” asks the Citi report.

Conversely, the possibility of a new US Homeland Investment Act (HIA2), which would allow for the tax-free repatriation of US corporate profits from abroad, gives some support to the dollar. It a policy response that is being voiced more frequently as a means to jump-start the flagging US economy, the report says.

Activity on InterContinental Exchange’s benchmark US Dollar Index remains a key guidance tool in determining the euro/dollar forecast, the bank says, given the near 60% weighting given to the euro in the index’s currency basket. The index is projected to register further gains this month, and to hold those gains over the medium term.

Among other currency pairs in the G10 group, Citi’s medium-term sterling forecast has been cut further compared with its last strategy update, from $1.73 to $1.61. Sterling weakness is inevitable in the short term, the report says. That’s due to the UK’s tight fiscal policy, coupled with loose monetary policy. Fiscal austerity may be beneficial for the pound in the long term, however, it adds, as the UK’s current account balance improves.

The yen, meanwhile, continues to be range-bound, as it has been for the past eight months, Citi notes, save for its rally and the subsequent G7 selling intervention after the Japanese earthquake in March. Otherwise, yen trading has assumed a regular pattern, as selling by exporters has capped upside price movements, followed by importers and retail investors buying on dips. The bank maintains a medium-term USDJPY forecast of 80, unchanged from last month.

Citi calls the correction in the Australian dollar in recent weeks long overdue, with the Aussie slipping from 1.10 in early May to a low of 1.04 in late June. The bank has trimmed its three-month AUDUSD target slightly to 1.02, citing Australian overexposure to flattening commodity prices and an over-reliance on Chinese demand. Citi raises its six- to 12-month target to 1.09, however, on expectations of Australian GDP growth outpacing the US’.

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