eur fundamentals

Euro/US Dollar Long-Term Exchange Rate Technical Forecast

Last month, I speculated that “the Euro/US Dollar remains vulnerable to weakness in a 5th wave (unfolding as an ending diagonal at this point)” and that “a rally above 1.3302 would suggest that a larger rally is underway towards Fibonacci resistance in the 1.36-1.41 zone.”  The Euro/US Dollar held its October low and soared in just the past few weeks to exceed even the 61.8% of 1.6040-1.2327 (1.45) and test the 200 day SMA.  The decline from 1.6040 can be treated as either a 3 wave decline (wave A) or a 5 wave decline (wave 1 with truncation).  Either way, a large range is probably unfolding now that may last the duration of January.  Former resistance in the 1.30-1.33 area should provide support for the lower end of the range.

Euro/US Dollar Exchange Rate Interest Rate Forecast

European and US interest rate forecasts have arguably played a larger part in recent Euro/US Dollar price action, as exceedingly low US interest rates has encouraged many traders to sell the US currency. Indeed, we saw the Euro rally substantially following the US Federal Reserve’s decision to cut interest rates to fresh record lows. European Central Bank interest rate forecasts remain similarly bearish, but few believe that the ECB could potentially cut rates to the same level as the US Federal Reserve. Given such dynamics, the Euro will very likely maintain a healthy yield advantage over its US counterpart—supporting the Euro/US Dollar through the foreseeable future.

Yet interest rate dynamics have arguably been priced in to current spot price, and poor European Central Bank rate prospects could potentially force further Euro/US Dollar weakness. Overnight Index Swaps currently price in a sizeable 150 basis points in ECB rate cuts through the coming 12 months—leaving the central bank’s repo rate at 1.00 percent. Yet the ECB has never taken rates below 2.00, and some central bankers have shown clear aversion to further aggressive rate cuts through the foreseeable future. It will be important to watch European interest rate dynamics—especially as it seems markets have become increasingly sensitive to yield differentials.

Euro/US Dollar Exchange Rate Valuation Forecast

Euro/US Dollar Valuation Forecast: Bearish

The Euro surged higher in December, adding over 11% to date against the US Dollar. However, the Euro also tops the list when it comes to adverse interest rate change expectations: overnight index swaps suggest the dollar will gain the most in yield against the single currency. Also working against the Euro, it remains highly overvalued as compared to the exchange rate implied by purchasing power parity. Finally, our Speculative Sentiment Index suggests open interest has fallen substantially in recent weeks, alluding to illiquid markets prone to knee-jerk volatility. This puts the significance of the latest down move into question, for even though the market appears to be pricing in a considerably stronger Euro there are far fewer traders behind the move than at the last major turning point in the trend. On balance, while the recent performance in EURUSD is in every way impressive, the valuation outlook 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 the Organization for Economic Cooperation and Development (OECD). We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar. Currencies overvalued against the Dollar are denoted in RED, while those that are undervalued are denoted in GREEN.

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