The EUR/USD reached 1.28 following Draghi's comments last week, which replaced the long-standing "never pre-commit" with a Fed-like forward guidance: the Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time." Asmussen added to the dovishness: "ECB forward guidance goes beyond 12 months," "would not rule out new LTRO," and "a range of standard and non-standard measures" that the ECB can still utilize.
Where is the next level for the EUR/USD? I look at some of the fundamental drivers.
- The PMI spread suggests there has been a significant disconnect between the EUR/USD and the manufacturing indexes, and that the relative news flow is not driving the pair anymore. As can be seen in the second chart on the right, the link between EUR/USD and the relative news flow is periodic, and not always verified. That being said, the spread between the EUR/USD and its PMI-spread-implied level is more than 10 bps.
- The 1-month return of the EUR/USD is closely related to the relative performance of US and European stock markets. As can be seen below, the EUR/USD seems to have overreacted on the downside. It could suggest that the S&P 500 has further room to underperform, but such a disconnect has already been seen in the recent past (see blue circles) and ended up with a rebound of the pair.
3. If it is not about relative news flow or relative risky asset performance, it has to depend on monetary policy expectations. The EUR/USD is currently at fair value if the relative OIS 1-year or 2-year slope spread is taken into account (more precisely, the 1-month change of the EUR/USD is consistent with the relative changes of US and EUR OIS swap curves).
Looking further down the slope of sovereign curves is not useful at this stage. As can be seen on the chart below, the link between the EUR/USD and the T-note/Bund Spread is no longer valid.
It is not clear whether it depends on the relative changes in central banks' balance sheet, but what is clear from the chart above (right) is that the EUR/USD should be much higher if balance sheet management were taken into account (regardless of the Fed taper).
Summing up the charts, for the EUR/USD to continue to fall in the short run:
- We have to ignore relative news flow;
- US stocks have to underperform their European counterparts; and
- Monetary policy expectations have to be revised significantly: a) very aggressive ECB; and b) a misunderstanding of the Fed's dual mandate: the Fed will taper in September but the timing of the first rate hike remains far away - the shift of the Fed Funds future curve suggests a first hike in October 2014 against my call for Q2/Q3 2015.
Technically, there is still some room for a further decline of the pair down to 1.24. But it will increase the gap between the EUR/USD and its fundamentals rather than reflect the relative strength of the U.S. and eurozone economies and risky assets. I would not be surprised by a rebound in the short run.