Over the last few months I have written a few articles where I discussed my bearish view on the EUR/USD exchange rate, like my last one here. Additionally, I had a short position on the euro (NYSEARCA:FXE), but have in the meantime closed the trade. I think that instead of fundamentals the central banks' policies, on both sides of the Atlantic, have had a great impact on the EUR/USD path, increasing the possibility of unusually large and unexpected (and usually abrupt) price swings.
This leaves investors especially vulnerable to losses in the short-term, implying that you should take a medium to long-term view and stick to it, or trade more actively and change your view more often. For instance, last July when Spain was under the spotlight and its yields were skyrocketing, the euro was rapidly losing value against the dollar until remarks from the ECB's president Mario Draghi that the central bank would do whatever was necessary to preserve the euro reversed the negative euro trend of the previous months.
Since then the euro has been on a positive trend supported by several factors, namely the Fed's QE3, the U.S. Presidential election, and the ECB's bond purchase program. However, the euro has failed to remain above the 1.30 support level, and over the last few weeks has moved sideways due to negative headlines both in the U.S. and Europe. The reality is that downward factors are weighing on both sides of the cross, leading to a misleading stable exchange rate. So, what is expected over the next few months? There are clearly both valid bull and bear arguments for the EUR/USD exchange rate, which make the short-term outlook a two-way bet.
Bull & Bear Cases
On the bull side, there is mainly the issue with the approaching fiscal cliff. The uncertain outcome of it, or at least when a compromise will be reached, should be negative for the USD. The focus on the economic and political impact of the fiscal cliff should remain for a few more weeks barring a rapid, and unexpected, political arrangement on the subject.
Recently, the Congressional Budget Office has estimated that if the fiscal cliff isn't avoided and is implemented (the reversal of tax cuts and automatic spending cuts), it could drive the U.S. economy back into recession next year. This slower growth outlook should increase risk aversion. The greenback is usually seen as a safe currency, but with the increasing U.S. specific risk it should lead to a period of USD weakness.
Even though these issues focus on U.S. domestic politics, but have naturally global consequences, it probably won't be a strong catalyst for the euro as investors will demand other safe haven currencies, such as the Swiss franc (NYSEARCA:FXF) or the Swedish krona (NYSEARCA:FXS).
On the bearish case, two major factors weigh negatively on the euro, namely Europe's sovereign debt crisis and the weak growth outlook. This last point was recently confirmed by the European Commission which cut its 2013 GDP growth forecast to 0.1%, from 1% estimated only a few months ago.
Moreover, last week's Eurozone GDP data for the third quarter showed another quarter of negative growth, confirming that the Eurozone has slipped back into recession for the second time since the global financial crisis of 2008-09. Furthermore, with the Eurozone economic slowdown spreading to Germany, which was over the past year the economy more resilient to the crisis in Europe, the euro is probably unable to make much gain versus the USD.
The ongoing European sovereign debt crisis, and more specifically Greece, also continues to be a fundamental issue making a cap on euro upside. This theme should continue to make headlines over the next few months, as Greece will likely need a third bailout program just as ECB's Asmussen said recently, since expectations that the country can regain access to capital markets by 2015/2016 appear unrealistic.
Regarding interest rates, the ECB's and the Fed's rate decisions should be neutral, at least in the short term. Although the ECB's benchmark rate is higher at 0.75% and will probably be lowered over the next few months, this is already priced in given that the US and EUR 2Y Swap rates are trading practically at the same rate (around 0.4%).
Although the fiscal cliff can be a negative risk to the USD, I see it as a short-term risk and much less worrying than the fundamental issues from which the euro continues to suffer. Given the usual investor's short-term bias, this makes the EUR/USD very susceptible to headlines, and a sideways move between 1.25-1.30 is likely until the fiscal cliff uncertainty is behind us.
In the medium term, I continue to have a bearish view on the euro as many of its fundamental issues continue to be addressed by Europe's politicians. For investors, this means that EUR/USD around 1.30 should be a good short opportunity, which can be played through a short ETN like Market Vectors Double Short (NYSEARCA:DRR). However, investors should have caution given that this is a leveraged play and use a relatively tight stop-loss.
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.