It is possible that the EURUSD decline from the May high is the beginning of something ‘bigger’ but at this point there is no evidence to support such an assertion. In fact, the decline appears as nothing more than a correction when viewed in the context of several years’ data. Trendlines and channel lines remain intact and RSI has turned up from near 50 several times – all information that is supportive of additional strength. Allowing for near term weakness, (support expected in the mid 14200s), I am looking higher into measured levels at 15125-15266 and the trendline that extends off of the late 2010 and May highs.
Euro / US Dollar Interest Rate Trading Bias: Neutral
The Euro/US Dollar currency pair has almost completely disconnected from relative interest rate expectations, remaining near significant highs despite a substantial downgrade in yield expectations. The European Central bank is now expected to cut interest rates by a negligible sum through the coming 12 months. Similarly muted US Federal Reserve expectations nonetheless suggest that forex traders look to other factors to determine trends for the recently-choppy EURUSD.
EURUSD correlations suggest that the Dow Jones Industrial Average and broader barometers for financial risk sentiment will continue to drive Euro and US Dollar moves. In fact the correlation between the Dow and EURUSD trades just short of record-strength, while the connection between the Euro and ECB rate forecasts is very weak.
Now more than ever, watch the Dow, S&P 500, and other key financial risk sentiment barometers to guide moves in the Euro and US Dollar currencies. The next moves may prove pivotal.
The Euro remains acutely overvalued, trading over 3000 pips above its PPP-implied fair value to the US Dollar. The case for a correction is compelling, with EU officials continuing to dither on a meaningful solution to the region’s debt crisis and a correlation to the S&P 500 – a proxy for broad-based risk appetite trends – pressuring prices lower as eroding global growth expectations weigh on sentiment. An eroding ECB interest rate hike helps as well, with trades now looking for at best a neutral posture from Jean-Claude Trichet and company for the year ahead. On balance, losses are favored going forward.
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.
