EUR/USD Enters 2017 Positioned for More Downside
After a quiet start to the year, we were hoping for a more exciting last few months of 2016. Sure enough, Q4’16 ended with a ‘bang.’ The stretches of low volatility seen in EUR/USD during Q2’16 and Q3’16 gave way to significant price developments in Q4’16, catalyzed by central banks and political developments on both sides of the Atlantic. Going forward, the factors that led to EUR/USD breaking through its March 2015 cycle low in Q4’16 will likely maintain their influence into Q1’17.
On the US Dollar’s side, the decision in December 2016 to signal three rates in 2017 – as opposed to the market-priced two ahead of the policy statement – has sent US Treasury yields higher. As a gauge of long-term growth and inflation expectations, the US Treasury yield curve steepening is a reflection of the market's belief that tighter monetary policy is coming in the near-term.
The main reason why US Treasury yields have been going higher has to do with the dramatic shift in market expectations for US fiscal policy. Given the expectation of a Democratic Clinton victory with a split Congress, more gridlock in Washington DC – and thus more fiscal stagnation (‘continuation’ as we called it in the Q4’16 forecast) – was anticipated. However, with the Republican Trump victory and Republican sweep in Congress, market participants think gridlock may retire to the pages to history (‘disruption’ as we called it in the Q4’16 forecast). In the 18 years since 1965, when one party has controlled both Congress and the White House, the US structural budget deficit has increased by +0.4% per year. Budget deficits tend to be inflationary, which if in turn translates into a more hawkish Fed, EUR/USD should have a reason to continue lower.
On the Euro side, the European Central Bank’s decision in December 2016 to alter its QE program proved significant. In our Q4’16 forecast, we said “The ECB will very likely be forced to remove the -0.40% barrier (allowing more German bunds to be purchased), or to remove the capital key restriction (allowing more peripheral sovereign debt to be purchased).” By going the former route as opposed to the latter, the ECB has primed the Euro to be in a disadvantageous position if interest rates elsewhere continue to rise.
Previously, yield curves in Europe were flattening as investors front-ran ECB bond-buying: with the ECB saying it wouldn’t buy debt with yields to maturity below the deposit threshold of -0.40%, there was a scarcity effect along the yield curve. This is no longer the case now that the ECB will buy bonds at any YTM, which reduces the need for investors to buy bonds at longer tenors down the curve. Concurrently, with the decision to buy 1-year debt, the ECB has signaled that it is altering policy to keep the front-end of European yield curves pinned as low as possible – even in increasingly negative territory.
On the surface, both US Treasury and German Bund yield curves are steepening – but they are doing so for very different reasons. With the UST yield curve, it is a result of both short- and long-end yields running higher, but with longer-dated bonds showing the sharper increase in yield – a bear steepener. With the German Bund yield curve, short-end yields are falling faster than long-end yields are rising – akin to a bull steepener.
Chart 1: EUR/USD versus German-US 2-year Yield Spread (June 20 to December 19, 2016)
In the first week of November, when EUR/USD traded near 1.1140, the German-US 2-year yield spread was roughly -145-bps. At the time this report was written (the week of December 19, 2016), with EUR/USD trading near 1.0420, the German-US 2-year yield spread was -205-bps. The 20-day correlation between EUR/USD and the German-US 2-year yield spread was +0.833, confirming the significance of relationship at present time. In conjunction, these twists and shifts in the US Treasury and German Bund yield curves have pushed out the German-US 2-year yield spread. This will be the most important factor to watch for EUR/USD going forward, particularly as the relationship between yields and EUR/USD appears to be such a significant driver (if the spread were to widen another 50-bps to -250-bps, then EUR/USD could trade near 0.9500, for example).
By the end of Q1’17, traders should start to pay more attention to European politics. On March 15, 2017, the Dutch elections will be held, the first of four significant elections in 2017. After the dramatic ‘No’ result on the December 4 constitutional referendum, Italy will likely head to the polls again by mid-2017. Luckily, for the Euro, the lack of reform that cost Matteo Renzi his job as prime minister may keep the Italian political system broken enough to prevent the Five Star Movement from ever achieving enough power to pull Italy out of the European Union. In April and May 2017, French presidential elections will be held, and the country will face its own populist threat in Marine Le Pen. Later in 2017 (date TBD), German elections will be held amid an environment in which Angela Merkel’s popularity Is quickly sliding (at five-year lows in December 2016) thanks to her immigration policy and an expanded terrorism threat in Europe. Needless to say, for those who thought 2016 was a year of surprises and shocks, 2017 is sure not to disappoint.
Technicals: EUR/USD Turn Lower
We were looking for signs of a turn higher in Q4’16, but that didn’t happen. Instead, EUR/USD broke lower in a significant way. In our Q4’16 EUR/USD forecast, we wrote about the extremely coiled environment persisting in the pair, noting, “according to the measure, EUR/USD is the most coiled in history. It’s been 81 weeks since the last 52-week high or low. The previous record was 77-weeks, which ended with the breakout in May 2002.” Furthermore, “if the March 2015 lows break, then the call for a bottom is wrong and focus would shift to 0.9450-0.9550 (historical inflection point and measured objective).” This zone is in play in Q1’17 and is reinforced by the 61.8% retracement of the 1985-2008 rally at 0.9608.
The underside of the 1985-2000 trendline, which broke in November, should be watched for resistance in Q1’17 quarter in the mid-1.0900s. With that line broken, it’s worth following parallels of the line that extend off of the 1995 and 2008 highs. The parallel that extends off of the 2000 low is near 1.0100 and should be watched for support. The low made after the December FOMC is the 1997 low. That level did break eventually but not without considerable struggle (circled on the chart). Something similar (back above 1.0900 before an attempt lower) wouldn’t be a surprise given the obsession with parity.
Strength through the median line from the bearish channel, which was resistance throughout 2016, would trigger a major bearish trap and shift focus to the downtrend line in the mid-1.2000s later in the year (fitting with the idea of the US Dollar rising then falling over the course of 20170.
Written by Christopher Vecchio, Sr. Currency Strategist and Jamie Saettele, CMT, Senior Technical Strategist for DailyFX.com
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