In spite of the looming taper, the EUR/USD is drifting higher. It may be because the ECB was not as dovish as expected. Is it sustainable?
The spread between the relative 2-year/3-month swap curves would call for a significantly lower EUR/USD (the disconnect is noticeable both in relative variation and in absolute terms).
This message is to be confirmed by the current reading of risk reversals. If the EUR/USD were to drift higher, the relative positioning of implied volatilities would be inverted.
The relative stock market performance suggests that the EUR/USD has gone too far. By this I mean that given that the monthly change in the EUR/USD is inversely correlated to the relative return of the Eurostoxx 600 against the S&P 500, the recent outperformance of the US stock market would call for a lower EUR/USD.
The pair failed to track the relative performance of bank stocks on both sides of the Atlantic. As can be seen below, the EUR/USD should have declined by -1% over the month according to this metric. The anomaly lies on the FX side, not on the proper behavior of bank stocks, as the relative performance of bank stocks has continued to track the relative changes in sovereign slopes in the US and Eurozone (second chart right).
Therefore, the EUR/USD has a problem with the (sovereign) curves. The forthcoming divergence in monetary policy and its likely impact on 2-year sovereign yields is signaling that the EUR/USD has plenty of room to fall in 2014. Yet, recent price behavior is showing a clear cut disconnect, even when short and long tenors are taken into account (Chart below).
Could it be that the ongoing problem lies on the dollar side? To me, the inability of the USD to strengthen in the wake of better economic news flow and a forthcoming tightening is puzzling.
It can be seen below that the DXY has not been able to follow the message from the weighted average of short run swap rate spreads. The causes are unknown but the correlation chart on the right (positive correlation of daily changes in the DXY with those of the UST Treasury yields and the economic news flow - even though the latter is clearly negligible) suggests that the odds for a stronger USD remain.
(click to enlarge)On the macro side, the relative PMI spread suggests the EUR/USD is slightly overvalued as well. Given my limited upside for the Eurozone growth in 2014 (creditless recovery), the PMI spread should not diverge significantly more over the next few months.
The main thing keeping the EUR/USD high is the structural strength (current account balance), as can be seen in the chart below, but its impact on short run moves is clearly limited.
Bottom Line: many cross asset signals (yield curves, relative stock market performance) would suggest that the EUR/USD (FXE) has gone too high recently, calling for a retrenchment of the pair as it nears its medium run resistance of 1.3922. Part of the rationale is dollar-related as the recent behavior of the DXY would suggest. Yet, in a context of tapering, stronger growth and in the absence of significant budget risk ahead, the odds for a correction for the EUR/USD are definitely increasing.