Is EUR/USD Parity Inevitable?

Reading this article in the WSJ “Hedge Funds Try ‘Career Trade’ Against Euro“, it would seem that there is an increasing amount of investors, especially hedge funds, looking for the EUR to fall to parity against the USD.  It is hard to believe that only a few months ago it looked as though the EUR was heading back towards its previous highs around 1.60 hit in April 2008. 

Following the surge in the USD during the financial crisis EUR/USD dropped to below 1.25 in November 2008 and then managed to eek out some gains as risk appetite improved and the USD came under pressure during most of 2009.

The picture towards the end of 2009 reversed as initially investors covered short USD positions and then bought USDs on rising risk aversion and growing problems in Greece.  The trend looks well set now and a move even lower beckons for EUR/USD.  

So how low will it go?  It is tempting to say that record short speculative positioning in EUR/USD means that the market is already stretched and like an elastic band pulled too far the EUR could rebound sharply.  On the other hand the band could also snap and in the case of EUR/USD this would imply a collapse in the currency as other investors join the bandwagon of selling EUR.

It is difficult to see any quick resolution to the problems in Europe at present.  Growing social/ labour unrest in the wake of austerity measures to cut burgeoning fiscal deficits highlight that implementing budget cuts mean tough political choices.   Greece has borne the brunt of this unrest but it appears to be spreading across Europe.   

In the past countries could devalue their way out of their debt problems but this solution is not available to individual countries in the eurozone.  Another option is to inflate your way out of the debt but again this is something that the European Central Bank (ECB) will not tolerate and could do much greater long term damage.  

So the only viable solution is to cut spending, raise taxes, implement reforms and raise retirement ages, all of which will fuel plenty of tensions in the countries concerned.  The difficulty of raising taxes was highlighted by the fact that even Greek tax inspectors have gone on strike, a fact which makes a mockery out of the government’s plans.  

Assuming that austerity measures are actually carried out it will mean that growth in Greece and many of the other bigger countries in Europe that carry out these measures will weaken further, making a “double-dip” scenario for the eurozone economy more likely.  

The bottom line is that it is extremely difficult to see the EUR make a sustainable recovery against this background.  Yes, the market is positioned short but so what? We may see short positioning increase further before any stability in the EUR is achieved.   

The last time EUR/USD was at parity was in December 2002.  Given the lack of alternatives in Europe at present another test of parity does not look as inconceivable as it did only a few months ago.


Disappointments Galore

Well the calm at the beginning of the week did not last very long.  Although the overnight price action can hardly be labelled as panic given both FX and equity volatility remain relatively well behaved, there is no doubt that worries are creeping back into the market psyche.  It seems that markets are once again trading on each piece of news and for the most part the news is not encouraging.  

A plethora of disappointments will set a negative tone for markets today.   Risk has come off the table in the wake of the worse than expected February German IFO business confidence survey and US Conference Board consumer confidence.   Cautious comments by Bank of England Governor King in which he kept the door open to further quantitative easing and a ratings downgrade of four of the largest Greek banks has added to the damage.

The German IFO was likely dealt a temporary blow by severe weather conditions.   The 10.5 point fall in US consumer confidence from an already relatively low level had no mitigating factors however, and revealed a deterioration in job market conditions, which combined with renewed weakness in jobless claims, does not bode well for next week’s US payrolls report, pointing to a decline of around 40k in February payrolls.

Overall, the market mood has darkened and there is little to turn sentiment around in the near term.  In prospect of likely weak reading for US payrolls next week and continuing worries about European fiscal/debt problems any improvement in risk appetite is likely to be limited.  This will help bond markets, the USD and JPY but most risk trades will face pressure. 

It is still worth being selective in FX markets.  The EUR remains the weak link and is set to struggle to make any headway, with upside likely to be restricted to resistance around 1.3747.  Similarly GBP is set to struggle in the wake of King’s comments as well as ongoing economic and deficit concerns, with GBP/USD vulnerable to a drop to around 1.5293.   In contrast, Asian currencies and commodity currencies look far more resilient.

Risk Appetite Puts Dollar On The Back Foot

Markets look somewhat calmer going into this week helped by comments by Fed members who noted that the discount rate hike did not signal a shift in monetary policy, something which is likely to be repeated by Fed Chairman Bernanke in his testimony to Congress on Wednesday and Thursday.  A tame US January CPI report last Friday helped too, giving further support to the view that the Fed will not hike the Fed Funds rate for some time yet; a rate hike this year seems highly unlikely in my view.  

Data this week will be conducive to a further improvement in risk appetite and despite the lingering concerns about Greece the EUR may find itself in a position to extend gains.  In Europe all eyes will be on the February German IFO survey and eurozone sentiment indicators, which following the surprising strength in the manufacturing Purchasing Managers Indices (PMIs), are likely to reveal solid gains. 

The main highlights in Japan this week includes January trade data and industrial production. The trade numbers will be particularly important to determine whether the rebound in exports due in large part to robust Asian demand, has continued whilst the bounce back in exports will be a key factor in fuelling a further gain in industrial output. 

In the US aside from the testimonies by Fed Chairman Bernanke there are plenty of releases on tap including consumer confidence, new and existing home sales, durable goods orders and a likely upward revision to Q4 GDP.  For the most part the data will show improvement and play for a further improvement in risk appetite. 

FX direction will depend on whether markets focus on the potentially positive USD impact of a reduction in USD liquidity or on the likely firmer tone to risk appetite this week.  Given expectations of firmer data and the soothing tone of the Fed, risk currencies will likely perform better, with crosses such as AUD/JPY favoured.  The USD will likely be placed on the back foot, especially given the very long market positioning in the currency.

The EUR will be helped by the fact that speculative market, according to the CFTC IMM data, holds record short positions in the EUR (as of the week ended 16 February) giving plenty of potential for short-covering.   The more timely Tokyo Financial Exchange (TFX) data also reveals that positioning in EUR/JPY has continued to be scaled back.  

CFTC Commitment of Traders (IMM) data – Net EUR speculative positioning

EUR/USD bounced smartly from its lows around 1.3444 on Friday, partly reflecting some short covering and the drop in FX volatility suggests the market is more comfortable with EUR/USD around these levels.  A positive IFO survey and improved risk appetite could see EUR/USD test resistance around 1.3774, its 20 day moving average, over coming days.  Ongoing Greek concerns suggest that any EUR bounce will be limited, however. 

USD/JPY looks well supported and although data this week will suggest that exports are improving despite JPY strength, the relatively more aggressive stance of the Fed compared to the BoJ, long JPY positioning, and improved risk appetite, give plenty of scope for the JPY to extend losses, with technical USD/JPY support seen around 91.28.

Fed discount rate move boosts dollar

The Fed’s move to hike the discount rate by 25bps has set the cat amongst the pigeons.   Although the move was signalled in the FOMC minutes yesterday a hike in the discount rate was not expected to happen so soon.  The Fed sees the modifications which also include reducing the typical maximum maturity for primary credit loans to overnight, as technical adjustments, rather than a signal of any change in monetary policy. 

Nonetheless, the market reaction has been sharp, with the USD strengthening across the board and short term interest rate and stock futures falling.  Although the reaction looks overdone and will likely be followed by some consolidation over the short term, the move will be interpreted as the beginning of a move towards monetary policy normalisation despite the Fed’s insistence that this is not the case.  The firm USD tone is set to remain in place for now but the bulk of the strengthening has likely already occurred following the announcement.  

The Fed’s desire to reduce the size of its burgeoning balance sheet, which at $2.3 trillion is roughly around three times its size before the financial crisis began, will imply further measures to reduce USD liquidity over the coming months.   A withdrawal of liquidity could have positive implications for the USD but given that the Fed is still some months away from hiking the Fed Funds rate, interest rate differentials will not turn positive for the USD for a while yet. 

The move has however, changed the complexity of the FX market and likely shifted currencies into new lower ranges against the USD.  There were plenty of reasons to sell EUR even before the Fed move and the discount rate hike inflicted further damage on EUR/USD which dropped below the key psychological level of 1.35.  GBP and commodity currencies were also big losers, with GBP/USD below 1.55.  Key technical support levels to watch will be EUR/USD 1.3422, GBP/USD 1.5374 and AUD/USD 0.884.

US Federal Reserve Balance Sheet ($trillion)

Euro Still Vulnerable

Markets have become rather skittish, with attention gyrating between sovereign deficit/debt concerns on the one hand and better news on the corporate and economic front on the other.  This week the latter appears to be gaining the upper hand helped by an easing of concerns about Greece. Although the Greek saga is by no means close to an end, especially given the new deadlines set by the EU Commission on adherence to budget cuts, the chances of the worst case scenario of default or pull out from the EU looks to have diminished. 

Renewed attention on other EU members, especially in light of the derivatives transactions carried out by Greece and potentially by other European countries to disguise the extent of their budget problems suggests that there is still more pain ahead. Nonetheless, it is increasingly clear that investors are differentiating between Europe and the rest of the world much to the chagrin of the EUR.  

Differentiation between the eurozone and the US was particularly apparent in the wake of stronger than forecast earnings and data in the US. Two more companies joined the three-quarters of S&P 500 companies beating earnings forecasts whilst economic reports including US January industrial production and housing starts came in ahead of forecasts.  This pattern is set to continue today, with the US Philly Fed manufacturing index set to increase to around 17 in February from 15.2 in January. 

In contrast, data in Europe has been much less impressive, with for example, the February ZEW survey of investor confidence recording its 5th consecutive decline in February.  The eurozone economic news may look a little better in the form of likely increases in manufacturing Purchasing Managers Indices (PMIs) but unless the data reveals particularly strong readings the growing perception that Europe is falling behind in the recovery process will remain in place.

Despite the improvement in risk appetite the USD has taken a firmer tone, appearing to react more to positive data and implications for a reduction in policy accommodation by the Fed.  In particular, the USD was spurred by the FOMC minutes of the January 26-27 meeting, in which the Fed debated its exit strategy from quantitative easing.  Some officials even went as far as pushing for asset sales in the “near future” to reduce the size of the Fed’s balance sheet.

Even though the USD has taken a firmer tone it will continue to be buffeted by the conflicting forces of improved risk appetite and shifting interest rate expectations.  Correlations reveal that risk is still the dominant FX factor suggesting that there may still be some further downside left for the USD as risk appetite improves. 

Although commodity currencies have also come under pressure due to the generally firmer USD tone overnight, the downside in these currencies is likely to prove limited especially given strong data releases.  For example, data overnight revealed that business confidence rose to its highest level in 15 years in Australia.  Added to upbeat comments from RBA deputy governor Lowe and strong labour market data, it highlights the growing probability of a March rate hike by the RBA.

The EUR remains the weak link and although it may benefit from easing Greek concerns the growing evidence of a relatively slower economic recovery in the eurozone suggests any upside in the EUR will be limited.  Having dropped below technical support around 1.3580, EUR/USD looks vulnerable to a further push lower in the short-term.

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