EUR/USD: 1.14100 Is In Sight

by: Hedge Insider

The euro is starting to recover against currencies including the U.S. dollar.

The author believes the EUR/USD pair could achieve a price of 1.14100 over the short-to-medium term.

The interest rate differentials are improving in favor of the euro. While the carry is still negative, these improvements are helping to drive the euro higher.

Given the mostly positive correlation between the euro and the gold price, a pullback in stocks this Easter (as stocks are now close to all-time highs) could help gold surpass $1,300/oz, helping to support euro higher still.

The euro has been rising recently, and for those keeping track of interest rate differentials, it is perhaps unsurprising. It is firstly important to note that euros are currently offering negative carry; in other words, the interest rate differential is negative when measured against other major currencies (see chart below). Borrowing a major currency like U.S. dollars to purchase euros is currently a losing proposition if measured purely on the yield (not price).

(Please note that the chart below uses multiple y-axes to improve visibility of yield differential changes.)

Euro Yield Differentials (Chart created by the author using charting tools. The same applies to all further price charts presented herein.)

The yield for each currency is taken using one-year interest rates offered by the market on government bonds as they relate to each respective currency (German bonds were used for the euro).

Using short-term (one-year) interest rate differentials with respect to alternative currencies, the chart above shows firstly, as mentioned, that the euro offers a negative carry against basically all major currencies. This means that borrowing one currency, such as U.S. dollars, and using those U.S. dollars to purchase euros, saddles a trader with a net carrying cost. Hence why, naturally, the euro has been bearish for some time.

Nevertheless, these adverse rate differentials (not in favour of the euro) have improved recently. The chart shows that while the differential has not made much progress versus the pound sterling (in yellow), which remains under the strong influence of Brexit headlines, the euro yield differential has generally improved in terms of Australian dollars, Canadian dollars (except for a recent pullback), the Japanese yen (more recently), and the United States dollar (most visibly, shown by the blue line).

It is interesting to see that the one-year net carry still remains negative to the tune of almost 3% against the dollar. The daily candlesticks, representing the EUR/USD pair, show the long-term (albeit volatile) sell-off in the euro since at least September 2018. However, the recent jump in the euro against the U.S. dollar signals a potential turn. The chart below is similar to the one shown above, except that the interest rate differentials are averaged.

Euro Net Average Yield Change The chart above, with the average net yield differential shown on the far-right y-axis, has been indexed (the value shown on the axis is not relevant; we simply pay attention to the change in this chart).

While the net yield differential has tailed off recently, on average, it has clearly improved significantly since around November 2018. Notably, the euro looks better positioned for upside today it was in September 2018, when EUR/USD was flirting with the 1.18 level. It is of my opinion that this story does not necessarily need to continue in order for the EUR/USD pair to achieve a level at least in line with recent highs:

EUR/USD to 1.14100 A level of 1.14100 over the short-to-medium term appears likely; a run to this level would create enough liquidity for the euro to then either return its long-term sell-off (which I would not rule out), or to break out further. Which way it goes from that point will depend on where yields move from between now and then.

It is also important to note that gold has been driving higher recently, which is inversely correlated with the dollar. Given that the euro is seen as a major global "alternative" currency to the U.S. dollar, the euro will usually move with a positive correlation to the gold price. If the dollar falls, sending the gold price higher, this will usually send the euro upward alongside gold. Below is a chart showing EUR/USD against a backdrop of the gold price and the U.S. dollar index (often referred to as DXY).

EUR/USD Gold Correlation

At the bottom of the chart we have the rolling 20-day correlation between EUR/USD and gold, which as you can see is positive most of the time. However, it is admittedly not always positive, and divergences do occur (although these divergences often provide us with trading opportunities).

What we can see as of recent is a flat-lining dollar (per DXY, which disproportionately weights the U.S. dollar against euros versus other currencies). DXY is struggling to break past the 97 level. Meanwhile, the gold price is struggling to stay above $1,300/oz. Nevertheless, with the dollar struggling and yield differentials improving in favor of other major currencies, a bearish dollar could send gold higher, and could support euro's climb higher. This would be the author's base case over the short-to-medium term.

Further, the recent bullish recovery in equity prices is likely at least partially responsible for the difficulty that gold is having in breaking the $1,300/oz level.

SPX vs. Gold However, with the S&P 500 now above 2900, a key level near all-time highs, we may well see some kind of pullback, which could help gold break the $1,300 level and continue its still-upward trajectory. This could further support the euro while its yield differentials are generally improving.

And as I wrote about recently, I see good potential for a bearish Easter this year; if this manifests, we could see the EUR/USD pair easily hit the aforementioned target of 1.14100 over the short-to-medium term. Make sure to keep an eye on the euro, and consider following me on Seeking Alpha if you enjoyed this article.

Disclosure: I/we 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.