Is The Euro Overvalued?

Sep. 29, 2020 7:01 PM ETDEUR, EUFX, EUO, FXE6 Comments
Splendid Exchange profile picture
Splendid Exchange
288 Followers

Summary

  • Some fundamental indicators reveal that EURUSD may be overvalued.
  • ECB President Christine Lagarde has recently set scene for further stimulus.
  • That does not mean, however, that going short EURUSD is a zero-risk trade.

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.

The Bearish Case

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.

This article was written by

Splendid Exchange profile picture
288 Followers
I trade commodities and high-yielding currencies. Fundamental analysis - 95%. Technical analysis - 5%.

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.

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