Is EUR/USD heading to 1.40?

Posted on 17. Feb, 2014 by Jean Jacques Ohana in Weekly Focus | Comments Off

The outlook of the dollar has been indecisive since Mario Draghi’s pledge to “do whatever it takes to save the euro” and the subsequent announcement of the QE3 Federal Reserve program. For sure, the emerging currencies have been hardly hit but the euro has served too as a repatriation currency during market stresses.

As showed in figure 1, currencies can be divided into 4 main groups:

  • The cross yen group. According to the Radar, there is still no ambiguity: the trend lies towards a depreciation of the yen.
  • The emerging currencies group. For sure, they are broadly under pressure. Meanwhile, there is sharp contrast between them. Eastern Europe currencies and the Israeli shekel show good resilience. Among the most fragile currencies, the Indian rupee is switching to positive trend but other currencies within the fragile 5 are hit: Turkish lira, Brazilian real, Indonesian rupiah, the South African rand. Meanwhile, there are some bubbles on the short side, which conveys extreme negative consensus on emerging currencies’ weakness.
  • The commodity currencies (AUD, NZD, CAD). AUD and CAD are in negative trends but the NZD stands out with a positive dynamic.
  • The European currencies. Among this group, GBP is ahead (with high trends and bubbles) and all other European currencies (bar the NOK) are in positive trends.

We present the evolution of the average trend indicator on each group (figures 2 and 3). Dynamics are synchronized over the long run but the current discrepancy between various trends casts a doubt on the direction of the dollar. Meanwhile, the increase in the gold’s trend towards neutral is worth noticing and comforts a more bearish outlook on the dollar.

From a fundamental point of view, we can wonder why the EUR/USD dynamic since the progressive withdrawal of QE3 (the so called “tapering”) has challenged the consensus so hardly. Riskelia called the consensus into question on several instances.

We have put forward at least three reasons supporting a strong euro. First of all, the Balance Sheet of the ECB and Fed still experience contrasting paths (figure 4). For sure, the tapering is slowing the increase in the Fed’s Balance Sheet but the one of the ECB is decreasing. The second main reason behind the strength of the euro is the increasing gap between anticipated inflation in the US and in the euro zone (figure 5). The structural reforms have weighed on inflation outlook in the euro zone whereas the inflation outlook in the US remained steady. Purchasing Parity states that the disinflationary trend in the euro zone increases relative competitiveness, thus favors a stronger currency in the long term. The decrease in euro zone inflation accounts for elevated real interest rates (France, Italy, Spain) which strengthens the attractiveness of the euro for international investors. Last but not least, the positive Eurozone current account (figure 6) explains the waves of repatriation of flows among investors and companies during market turmoil.

At Riskelia, we don’t like price objectives because we believe that there is no boundary on financial markets. But we have noticed that the consensus is shocked by the mere perspective of the EUR/USD quoting above 1.40, stating that the euro zone could not withstand such high level. As the ECB seems to have given up actively fighting against deflation, we think that some psychological level must be crossed to trigger a form of quantitative easing from the ECB. A breach of the 1.40 threshold could play this role.

 

Figure 1: Minimum Spanning Tree of main currencies. It represents the shortest path linking every asset. The distance measure is chosen as 1-|Correlation|. The color of the edge represents the strength of the correlation.



Figure 2: Riskelia’s trend indicators on main currencies clusters vs. USD



Figure 3: Riskelia’s Radar on G10 and emerging currencies





Figure 4: Federal Reserve and ECB Total Assets in billions USD and EUR



Figure 5: Inflation swaps on a 5 years maturity



Figure 6: US and Euro Zone current account as % of GDP



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