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EURUSD: Euro US Dollar Exchange Rate Forecast

EURUSD: Euro US Dollar Exchange Rate Forecast

2011-07-07 00:08:00
Joel Kruger, David Rodriguez, Ilya Spivak,
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Euro / US Dollar Technical Forecast

Weekly Chart

EURUSD_Euro_US_Dollar_Exchange_Rate_Forecast_body_EURJULY.png, EURUSD: Euro US Dollar Exchange Rate Forecast

Prepared by Joel Kruger

A closer look at the weekly chart shows the market confined to a longer-term downtrend off of the record highs from 2008, with the market now potentially looking to carve out a fresh lower top by 1.4940 ahead of the next major downside extension. Key support comes in by 1.3970, and a sustained break below this level should open a fresh downside extension and accelerate declines. Ultimately, only back above 1.5000 would give reason for concern.

Euro / US Dollar Interest Rate Forecast

Currency, Central Bank

Euro,European Central Bank

US Dollar, US Federal Reserve

Net EURUSD Spread

Signal

1-Year Expectations(Basis Points)

77

16

61

Bullish

Yield in 1 Year(Percent)

2.02

0.41

1.61

Bullish

EURUSD_Euro_US_Dollar_Exchange_Rate_Forecast_body_Picture_6.png, EURUSD: Euro US Dollar Exchange Rate Forecast

Euro / US Dollar Interest Rate Trading Bias: Bullish

Remarkably volatile European Central Bank interest rate expectations have led to similarly choppy moves out of the Euro/US Dollar pair, and the future of ECB policy will likely prove decisive for the single currency. Overnight Index Swaps currently predict that the ECB’s target rate will stand at 2.02 percent in a year’s time, a substantial advantage over the Fed’s forecasted 0.41 percent. All else remaining equal, interest rates favor EURUSD strength.

Yet it remains critical to watch how the ECB will react to continued stresses across European debt markets and whether they can stick to their monetary policy tightening cycle. Outgoing ECB President Jean Claude Trichet has repeatedly said that the central bank sets policy for the entire euro group—not a select few countries. Yet it may be increasingly difficult to ignore inflated bond yields across periphery nations, particularly as the spread between German bonds and Portugal, Ireland, Italy, Greece, and Spain’s debt trades at or near records.

Euro / US Dollar Valuation Forecast

EURUSD Valuation Bias: Bearish

EURUSD_Euro_US_Dollar_Exchange_Rate_Forecast_body_07062011_EUR.png, EURUSD: Euro US Dollar Exchange Rate Forecast

The Euro remains overvalued against the US Dollar, trading 21.3 percent above its PPP-implied fair exchange rate. While the hawks on the ECB appear unbowed, the focal point for the single currency has indisputably shifted to the sovereign debt crisis raging on the currency bloc’s periphery. In that regard, much of the landscape remains uncertain: the agreement on a second round of Greek aid seems to be showing cracks just a week after it was reached, with German officials once again calling for a controversial provision to force private investors to roll over their maturing Greek bond investments (which the ECB fiercely opposes on the grounds that it is equivalent to a technical default) while a downgrade of Portuguese debt to junk status at Moody’s brings the first signs of contagion.

The markets appear determined to test just how far EU officials are willing to go to avoid default, and it seems only a matter of time before policymakers lose the appetite to force ever-larger bailouts on already grumbling core European electorates. With that in mind, the uncertainty about what an actual default might unleash ought to keep the Euro moving lower, allowing for a deeper correction of the current disparity.

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.

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