There are some good reasons why the Euro is currently trading above its long-term moving averages. Divergent monetary policy between the European Central Bank (ECB) and the Federal Reserve (FED), widening 2-year and 10-year bonds yields spreads and relatively better debt situation in the EU (vs the U.S.) are usually cited as the main causes of the Euro relative strength. But how likely is EURUSD to strengthen further and move towards 1.20 as some analysts expect?
I do not think that the bullish case for EURUSD is strong enough. Range bound trading with a slight bearish bias is more likely to prevail. I see EURUSD trading in the 1.14-1.18 range over the next six months.
10-2 Yield Spread
One only needs to look at the chart below to ask an obvious question: is the Euro significantly overvalued?
Source: Bluegold Trader (website)
The chart above shows daily closing exchange rates for 1 Euro to U.S. dollars and the yield spread between the 10-year government bond and the 2-year government bond (10-2 yield spread). In this particular chart, the 10-2 yield spread is a simple difference between the yields on 10- and 2-year German government securities at constant maturity. German bonds were picked because Germany is the largest economy in the Eurozone accounting for 28% of GDP.
The yield spread is often included among the leading forex indicators because interest-rate spreads determine the shape of the yield curve and the shape of the yield curve embodies fixed-income traders' expectations about the economy. When the 10-2 yield spread rises, the yield curve is steepening (becoming more upward-sloping). Upward-sloping yield curves have normally preceded economic expansions as bondholders demand a higher rate of return from the inflationary risks accompanying economic upturns. When the 10-2 yield spread falls, the yield curve is flattening. Flat yield curves usually signal an approaching economic slowdown or expansion, depending on which stage of the economy had initially prevailed. When 10-2 yield spread dips below zero, it means that the yield curve is “inverted”. Inverted yield curves usually signal economic slowdowns and are often harbinger of recession. The negative slope of the yield curve shows that short-term yields are higher than long-term yields as bond traders expect lower interest rates ahead. Historically, yield curve inversions have started about 12 to 18 months before a recession.
As of today, the 10-2 yield spread in Germany is near all-time low, while the EURUSD exchange rate is trading near two-year high. I see a major bearish divergence here.
Trade balance, one of the most important macroeconomic indicators influencing the exchange rate, is not looking particularly good. As of July, the seasonally adjusted total trade balance was still down some 33% y-t-d despite the fact that the euro was 3% weaker at that time than it is today. Now that the euro has appreciated further and the 2nd wave of coronavirus is taking hold, EU the trade balance will almost certainly deteriorate in Q3 and Q4.
Source: Bluegold Trader, Eurostat
To make matters worse, Germany reported HICP inflation at -0.4% in September, which was a 30-basis point downward surprise vs market consensus. Therefore, core inflation is likely to have declined further including on VAT pass-through. The difference between Eurozone and U.S. consumer prices is now 150 basis points - the highest since August 2016.
Finally, ECB President Christine Lagarde has recently set scene for further stimulus. While speaking before the ECON Committee of the European Parliament today (see here), she struck a dovish tone, which signaled that further monetary stimulus is likely. Ms. Lagarde noted that "the recovery remains incomplete, uncertain and uneven" and that "the public health crisis will continue to weigh on economic activity and poses downside risks to the economic outlook". In addition, "the sharp drop in economic activity earlier this year has weakened price pressures" that inflation was "expected to remain negative over the coming months" and was "clearly far away" from the ECB’s goal. She concluded that "in the current environment of elevated uncertainty, the Governing Council will carefully assess all incoming information, including developments in the exchange rate, with regard to its implications for the medium-term inflation outlook. It continues to stand ready to adjust all of its instruments, as appropriate, to ensure that inflation moves towards its aim in a sustained manner, in line with its commitment to symmetry".
Indeed, it appears increasingly likely that the ECB will soon announce a step up in net asset purchases, which will obviously put a downward pressure on the euro.
The bullish case for EURUSD is unconvincing. Yes, there is no doubt that monetary policy in the U.S. is currently more dovish, while ECB is more cautious. However, the market is driven by expectations and if you wanted to play the divergent monetary policy theme, then you should have gone long EUR back in April. Going long on the basis of something as obvious as divergent monetary policy is too late now.
As I said in my previous article, the Euro ranked as one of the most overvalued currencies among 28 global currencies and as the second most overvalued currency among the seven major ones. The results are still valid today (see the latest charts below).
What is important is that the relative overvaluation of the Euro is rather broad-based. In other words, the results are above zero for all econometric studies plus traders' sentiment analysis.
Therefore, I would recommend either shorting a broad EUR index or to go short selected forex pairs - paritcularly, EURCAD, EURGBP. And if you prefer exotic pairs, EURRUB and EURMXN.
This article was written by
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.