Euro US Dollar Exchange Rate Forecast

The EURUSD has soared over 1300 pips from its June low to test the 38.2% retracement of the decline from 15144. This level is reinforced by former support from the March low. Former support often serves as resistance and that is the case here thus far. Structurally, the rally counts as a double zigzag (complex) correction. The 2 zigzags would be equal at 13420, which is a level to watch in the event of additional strength. The corrective rally combined with the presence of resistance favors bears in August.

Euro / US Dollar Interest Rate Forecast

The yield spread between the Euro and dollar has become a much more significant factor in price direction over the past month as concerns dissipate over the sovereign debt crisis. An uneventful European bank stress test has also help pave the way for a greater role for fundamentals. Signs that the recovery is sustaining in the region have raised the outlook for tightening from the ECB while a weak U.S. labor market has simultaneously sunk hopes of a Fed rate hike. The increasing spread which was negative in June has helped feed Euro support pushing the pair to a three month high.

The debt crisis has faded but repercussions from it are just starting to be felt, as banks have become reluctant to lend as the promises of sharp austerity measures have dimmed the growth outlook for the region. Therefore, the ECB will be hard pressed to raise rates and if they maintain their dovish outlook then the yield spread could swing back to the dollar’s favor putting pressure on the pair. However, a lack of job growth in the U.S. will also push out Fed tightening placing the pair in a stalemate.

Euro / US Dollar Valuation Forecast

EURUSD Valuation Forecast: Bearish

The Euro has staged an impressive rebound, aided by short-covering as traders digested the near-term implications of the EU debt crisis as well as a reversal in the yield landscape. Indeed, Euro 2-year returns overtook those of the US in July and now trade at the highest premium since February after the expiry of the ECB’s 12-month repo amounted to a large liquidity drain while US rate hike expectations evaporated amid softening economic data. Overall, the series of lower highs and lower lows from the peak in early 2008 points clearly to toward a downtrend, and prices are now trading at a 15.2 percent premium to the PPP-implied fair value, hinting that the current upswing ought to be treated as an opportunity to enter short at a more favorable level.

What is Purchasing Power Parity?

One of the oldest and most basic fundamental approaches to determining the “fair” exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. For example, if a pencil costs €1 in Europe and $1.20 in the US, the “fair” EURUSD exchange rate should be 1.20. For our purposes, we will use the PPP values provided annually by Bloomberg. We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar.