EUR/USD - A Case For Parity

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Summary

The pair suffered a bearish break below 1.11 handle earlier this month as markets gained more clarity regarding the timing of the next Fed rate hike.

CME Fed funds futures put the probability of a December rate hike at around 70%.

Bank of Japan (BOJ) has resumed steepening of the yield curve and that is likely to force similar adjustment across other advanced nations.

by Omkar Godbole, FXStreet.com

EUR/USD pair is finally witnessing action after having spent close to two months in a narrow range. The pair suffered a bearish break below 1.11 handle earlier this month as markets gained more clarity regarding the timing of the next Fed rate hike.

In the first quarter of 2015, wires were abuzz with reports stating the currency pair could drop to parity by Q2/Q3 2015. However, what we had is a rebound from 1.0463 to a high of 1.1714 by August 2016. A revisit to 1.05 levels was undone again as the pair recovered to 1.1616. To cut the long story short, the pair has formed a falling tops formation….especially since May 2016 we have had successive falling tops - 1.1616 (May 2016) - 1.1428 (NYSEARCA:JUNE), 1.1366 (Aug) and 1.1327 (NYSE:SEP).

Markets preparing ground for a Dec rate hike

CME Fed funds futures put the probability of a December rate hike at around 70%. This is just the level the Fed desires as it suggests there would not be a shock to financial markets due to a rate hike. Meanwhile, across the pond, European Central Bank (ECB) is unlikely to taper its QE program any time soon.

In case, we have a black swan event, the increased demand for treasuries is likely to make sure the dollar remains strong despite drop in Fed rate hike bets. Moreover, European banking system is more fragile, hence a potential black swan event could hurt EUR more than the US dollar.

Thus, in both cases; the rate differential appears in favor of the US dollar.

Steepening of the yield curve likely to hurt EUR

The ongoing steepening of the yield curve in Japan is not a matter of choice but something that is being forced on central banks by market forces. With the total face value of negative-yielding corporate and sovereign debt in the Bloomberg Barclays Global Aggregate Index of investment-grade bonds at $11.6 trillion as of Sept. 30, (up 6.1% from a month earlier), the system is looking increasingly unstable. Moreover, this cannot last for long; hence steepening of the yield curve is inevitable.

Bank of Japan (BOJ) has resumed steepening of the yield curve and that is likely to force similar adjustment across other advanced nations.

Note that flattening of the yield curve in Germany and other Euro zone nations via QE, negative rates were accompanied by a drop in EUR. Consequently, one may assume the steepening of the yield curve would strengthen EUR, which is to an extend true against high yielders like NZD, AUD which have been major beneficiaries of negative rates in Japan and Europe. However, steepening of the yield curve in Eurozone is unlikely to help EUR score gains against the US dollar. This is because rising rates elsewhere provides more room for the Fed to hike rates. In another scenario, a steep rise in long duration yields could derail equity market rally, in which case again the increased demand for US treasuries is likely to keep the Dollar solidly bid against EUR.

Furthermore, markets are penalizing the British Pound for 'Hard Brexit'. However, 'Hard Brexit' is equally likely to be 'Hard' on Eurozone…something that markets are currently not focusing on. Also note the political risks across Eurozone, which could further add to bearish pressure around EUR.

Technicals- Bearish golden crossover on monthly chart

Monthly chart

A bearish 50-MA and 200-MA crossover on monthly chart is on cards. Often dismissed as a laggard indicator, the crossover this time could be a signal of a further slide in the pair given the fundamental picture.

Also note the repeated failure to sustain above 1.1213, which is the 61.8% Fibo retracement of the rally from 0.8231 (2000 low) to 1.0638 (2008 high).

Given the falling tops formation, a break below 1.0911 would open doors for a slide to 1.0558. A violation there would expose trend line support on the monthly chart seen around 1.0181… which is just short of 1.0073 (76.4% of 0.8231-1.0638).

With all of this data all over the trading floor, we only can be cautious and try to perceive the swan before it becomes black.

Omkar Godbole, Editor and Analyst, joined FXStreet after working for four years as research analyst in number of Indian brokerages. Omkar holds a Masters degree in Finance and is deeply immersed in tracking financial markets across the globe.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: Omkar Godbole, Editor and Analyst, joined FXStreet after working for four years as research analyst in number of Indian brokerages. Omkar holds a Masters degree in Finance and is deeply immersed in tracking financial markets across the globe.