Euro US Dollar Exchange Rate Forecast

Euro / US Dollar Monthly Technical Forecast

To review - the 5 wave decline from the 2008 high above 1.6000 confirms that the larger trend is down.  The corrective rally may be nearing an end.  The advance is in 3 waves but wave C has yet to exceed wave A.  Normally, I would hesitate in labeling a truncation (in which C fails to exceed the end of A) but additional evidence bolsters the bearish case in this instance.  The ii-iv (of C) line served as resistance twice, slow stochastics on weekly and daily charts are divergent with recent highs, and there are interesting Fibonacci time relationships with the recent high.  Notice the arrows that at each significant turn.  Those turns occurred in October 2008 (3 months after the July 2008 high), December 2008 (5 months after), March 2009 (8 months after), and August (13 months after).  What’s the significance?  These numbers comprise the Fibonacci sequence  - 1,1,2,3,5,8,13,21,34,55,89,…  What’s more, the week in August that produced the recent top was a Fibonacci 89 weeks from the week in July 2008 that produced the top.  The probability is high that the next multi month move is lower.  A rally above the August high would suspend the bearish forecast until a test of the 2008 high at 1.4720.    

Euro/US Dollar interest rate forecasts have remained bearish but we have seen the spread narrow from -44 to -24 as the outlook for the Euro-Zone has improved. In fact Overnight Index Swaps were predicting 80 bps of rate hikes for the ECB over the next twelve months at the beginning of the month but have eased to 56 bps. Dovish talk from policy makers has weighed on expectations but the central bank’s mandate of maintaining price stability increases the chances that they will act swiftly to raise rates when conditions warrant.

However, the pair continues to see price action driven by risk trends and the dimming expectations for a global recovery will inspire risk aversion and should limit upside potential. Fears are that consumers and businesses will remain cautious following the shock of the credit crisis and once government stimulus evaporates downside risks to growth will increase.

Euro / US Dollar Valuation Forecast

EURUSD Valuation Forecast: Bearish

The Euro corrected a bit lower from the previous month but is still deep in overvalued territory, trading 2987 pips above its “fair”, PPP-implied exchange rate against the US Dollar. From a fundamental stand-point, the foundation behind Euro strength seems shaky: a survey of economists conducted by Bloomberg suggests the pace of Euro Zone economic growth will lag 1.4% behind that of the US through the end of next year, which likely means the Fed will lead the ECB in starting to raise interest rates once economic recovery solidifies. In fact, trading in overnight index swaps suggests the market is pricing in just that. Further, deflation is becoming an increasingly real possibility as CPI figures continue to print in negative territory while the banking sector is yet to come to terms with an estimated $1.1 trillion in unrealized sub-prime related losses (according to the IMF), a hit that could be compounded by defaults or devaluations in some of the newly-minted central European EU member states that are struggling with meeting their obligations to Western European lenders. Indeed, it is perhaps the prospect of these very losses that has undermined the ECB’s attempt to stimulate lending by allowing overnight borrowing costs to hover between 0.5 and 0.3 percent, well below the target 1% target level, with lending to the private sector growing at a record low 0.6% in July. The equities rally that has supported EURUSD gains since March looks to be losing steam, with Chinese shares leading the way lower, and September may be the month that markets the beginning of a correction of the current valuation disparity. On balance, our bias remains bearish.

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.