At the beginning of 2012, Europe's debt crisis and the euro (NYSEARCA:FXE) survival were two main issues worrying investors' minds, and the EUR/USD currency pair faced huge downward pressure due to concerns of a possible break-up in the Eurozone. However, on an annual basis the Euro showed a remarkable resilience during a period of crisis, and did increase a little against the dollar. This good performance was mainly achieved during the second half of the year, supported by hopes about the European Central Bank (ECB) policy, which resulted on much lower risk aversion and was a major catalyst for euro bulls to take long positions. Over the last two months of the year, the fiscal debate in the U.S. weakened the dollar adding another reason for the euro appreciation.
This positive trend can continue in the short-term, but the upside potential seems limited in a medium to long-term basis. Presently, the major factors affecting the EUR/USD future performance are the ECB and Fed monetary policy, the U.S. fiscal debate and Europe's debt crisis (not yet resolved). These factors show a mixed picture and can make the EUR/USD to trade in a relatively tight trading range, over the next few months.
Unlike the Federal Reserve and the Bank of Japan, the ECB is not keen to open the liquidity spigots. The ECB is pursuing the least expansionary policy of all major central banks, having an upward effect on the euro. It rallied from 1.30 at the beginning of the month, on the decision of the ECB to unanimously shun further rate cuts. The recent repayments by European banks of LTRO's loans taken in December 2011 showed their lower dependence on central bank liquidity, thus reducing the balance sheet of the ECB, and hence gave another short-term boost to the euro. Moreover, as long as the Fed maintains its current monetary policy, the EUR/USD will be more likely to rise than fall. Nevertheless, the cross has gained around 7.5% since mid-November and may face stiffer resistance at around 1.40, especially if Europe's policymakers become more concerned over the impact of a stronger euro.
The more expensive euro will act as a drag on the European economy because it will hurt exports, which is probably the only route that Europe has to return to economic growth during a period of austerity policies that are impacting negatively consumer spending, and increase inflation through higher food and fuel prices (imports). As a result, over the next few months it is possible to see growing speculation on a looser ECB policy. Interest rates have already started to rise in Europe since the beginning of the year, especially after Draghi's more positive speech at the latest ECB meeting. The 2y interest swap rate differential between Europe and the U.S. has increased lately and also supported the recent euro appreciation. But with consumers and governments still facing a deleveraging process and a European economy that is too weak to cope with a rising euro, the ECB probably won't make the same mistakes as it did in 2008 and 2011, when it increased its benchmark rate to rapidly reverse its policy, and this time will maintain its low interest rates for some time.
Another factor that has a great impact on the EUR/USD pair, is the political tensions in the United States. Despite its recent strength, the EUR/USD should not break the 1.40 mark unless the U.S. political tensions intensify in the coming weeks. With the debt ceiling debate postponed for a few months and a compromise on fiscal policy the most likely outcome, these events shouldn't act as a major downward pressure on the dollar in the next few months. However, if the EUR/USD eventually reaches 1.40, it can be a good level to bet on a downward movement on the pair. With the U.S. economy expected to outperform Europe and bond yields expected to rise more in the U.S., the dollar should strengthen over the next few months supported by a stronger economic outlook than in Europe. While GDP unexpectedly shrank 0.1% in the fourth quarter, it is forecast to expand 2% in 2013, compared with a 0.2% contraction in Europe.
The ECB announced in September its willingness to buy the sovereign debt of countries that asked for help, but as of yet, there have been no requests. The cap implicitly imposed by the ECB in sovereign bond yields, has so far been enough to improve conditions in the bond market. However, given the fundamental issues still unresolved in Europe, when investors start again to worry about the debt sustainability the ECB will be under pressure to act, resulting in another period of market stress and in strong downside pressure on the euro. Given the high level of complacency currently in the markets some minor event, such as Italian elections, might trigger a new period of tension in the bond markets.
Additionally, over the medium-term, the risk of a hard landing in China is also positive for the US dollar. Though recent economic data have improved, the Chinese economy is facing a structural deceleration over the coming years. Under such a scenario, the dollar should rally given its status of reserve currency. This may not be an issue over the next few months, but over the medium to long-term, it may be a tailwind for the greenback.
The EUR/USD can continue its upward movement towards 1.40, especially if the U.S. economy continues to show some short-term weakness or if the political tensions deepen over the next few weeks. Nevertheless, the pair is unlikely to exceed 1.40, as the fragile European economy cannot easily tolerate an expensive currency. Additionally, Eurozone tensions can also flare up again in the coming months, causing a drop on the euro. Based on these factors, a pullback to 1.30 is possible, but investors should wait until the EUR/USD appreciates a little further and then act accordingly.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.