Currency Analysis EURUSD

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Erste Group Research Currency Analysis EURUSD Page 1

Erste Group ResearchCurrency Analysis | EURUSD04. January 2012

Currency Analysis EURUSDDollar - safe haven for Eurozone crisis?Fed vs. ECB: Ever more complex, but slightly euro-negativeFundamental fair value at EURUSD 1.25Technical outlook: Sell euro rallies

Analysts:

Fundamental viewMildred [email protected]

Technical viewRonald [email protected]

The long-lasting discussion about the dollars status as a safe haven,

which is regularly contested, entered a new stage by mid-2011. Bythen, the Eurozone debt crisis also started to impact the EURUSDexchange rate (which prior to that was not the case). Due to persistentlybetter growth perspectives in the US and a lack of alternatives, we expectthe dollar to retain this safe haven status throughout 2012 as well.However, it is also worth mentioning that the quantitative extent remainslimited.

As a consequence of the debt crisis and corresponding downsiderisks to the Eurozone economy and inflation, we also expect the ECBto expand their monetary policy stance more than the US Fed in 2012,which is euro-negative. Despite the Feds ongoing Operation Twist andpossible forthcoming MBS purchases, the ECBs very generous liquidityprovision, expected rate cuts and possible further easing is likely to be ofgreater importance. This should also impact the interest rate differential,which should support the dollar on a relative basis.

Finally, long-term fundamentals (in particular, purchasing power parity,but also a still narrower trade balance deficit of the US and especially thedollars status as the worlds first reserve currency) also point to astronger dollar, so that we expect appreciation to EURUSD 1.25(perhaps even beyond) throughout the year.

Technical outlook: The current rebound may continue for some time and afurther rise to EURUSD 1.31 seems likely. Following this technical bounce,we believe that the euro-bears are most likely to strike again, as the overalltechnical bias remains clearly bearish. A sell the rallies approach isadvisable. We believe that trend acceleration may lead to a 1y low at 1.188(low June 2010). This should be the final leg of the downtrend and a verysolid support level. Afterwards, we envisage 1.26 as a major target on theupside.


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Fundamental Outlook

The dollars traditional status as a safe haven is as often confirmed asit is contested. Indeed, the property does not seem to be stable overtime, and in the dollars case appears to be threshold-triggered (sothat the dollar appreciates only in case of extreme financial marketstress). Indeed, there is no visible correlation of the EURUSD exchangerate with any measure of financial market stress, such as volatility (e.g., theVIX as in the following chart inverted on the right-hand side) or otherfinancial stress indicators. However, in the event of extreme stress (asmarked in blue in the following chart), the dollar almost systematicallyappreciates. Hence, in the event of renewed financial market turmoil, thedollar should appreciate further.

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EURUSD VIX, inverted rhs

Source: Bloomberg, Erste Group Research

Beyond that, the stress related to the Eurozone debt crisisincreasingly impacts the EURUSD exchange rate. In 2010, severalfactors counteracted the safe haven status of the dollar. For example, othersafe havens seemed more appealing on a fundamental basis (e.g., CHF),but have now been eliminated by central bank intervention. Furthermore,QE2 had contributed to a weaker dollar in 2010 (see next section). Sincemid-2011, the dollar has increasingly become a safe haven. This is visiblein the following chart, showing the onset of a co-movement of theexchange rate with peripheral yield spread increases. We expect thisto persist, but do not see it as any manifestation of a euro crisis, asthe extent of exchange rate sensitivity still remains relatively mild (in

contrast to the EURCHFs past reaction, for example).

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EURUSD 10Y Spread gips-DE, rhs inverted Source: Bloomberg, Erste Group Research

Analyst

Mildred [email protected]


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Besides perceived or real risk factors, the expected return of an asset

is of course one of the main driving forces of its price. Higher interestrates (or smaller monetary aggregates) support a currencys relativeattractiveness, so that the monetary policy stance is of greatimportance for the exchange rate.

As long as interest rates are strictly positive, nominal and real interestrate/yield differentials of different maturities are the main reflection of thecurrent and expected monetary policy stance. Short-term interestrates/yields are directly linked to the setting of the main refinancing rate. Weexpect the ECB to lower the main refinancing rate to 0.5%, which is alreadypriced in in 2Y yields. This points to the EURUSD decreasing towards 1.25quite rapidly.

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EURUSD 2Y Yield differential (rhs)

Source: Bloomberg, Erste Group Research

Once the short-term rate is at zero, the central bank can relax monetaryconditions further through balance sheet measures. In the case of theEURUSD, this will be one of the most complex issues in 2012. Anexpansion of the balance sheet (such as QE or expanded liquidity provision)can affect the exchange rate through the relative provision of currency, orexpectations in this respect. Indeed, the expansion of liquidity provision interms of maturity and collateral by the ECB has already led to a relativeincrease in the ECBs balance sheet as compared to the Feds (see thefollowing chart), thus exerting a weakening pressure on the euro. Weexpect the ECB to remain more generous than the Fed (even if the latter

were to consider MBS purchases), thus weakening the euro.

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EURUSD M0 US / M0 EU Source: Bloomberg, Erste Group Research


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The compositionof the CBs balance sheet (as opposed to its size) can

affect the exchange rate indirectly because of its potential impact on longerterm interest rates (for example, Operation Twist lowers long-term yields,while short-term yields are pegged down by interest rate expectations). Weexpect the ECB to lower rates to 0.5% and for them to remain there until2014 thus longer than the Fed.If necessary, the bank could also aim tolower long-term rates further (asset purchases similar to the Fed), so thatwe expect slightly more yield increases in the US than for theEurozone benchmark. This exerts a weakening effect on the euro.

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EURUSD 10Y Yield differential (rhs) Source: Bloomberg, Erste Group Research

Furthermore, from a fundamental and long-term perspective, there aresome other factors supporting the dollar. Most important from aquantitative perspective is the fair value of the exchange rate. Thisvalue is determined by the fact that the same good should cost the same inboth countries (Purchasing Power Parity). Of course, there are numerouslimitations for this approach (transportation costs, tariffs, not all goods aretradable, price and wage setting is sticky, one does not have an absolutemeasure for prices, only some relative proxies such as Consumer PriceIndices or Producer Price Indices with the exception of the famous but notentirely representative Big Mac Index). However, in the long run, exchangerates seem to return to their fair value based on relative price dynamics. Forsome of the reasons mentioned above, we have based our fair value onProducer Prices, and obtain a current fair value of EURUSD 1.25,which is our strongest argument in the medium term.

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EURUSD (DEMUSD prior to 1999)

EURUSD Fair Value (PPI US/ PPI EZ indexed on 1999 EURUSD) Source: Datastream, Erste Group Research


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Finally, the trade balance, and in particular the balance of payments

inflows due to the dollars status as the first reserve currencyworldwide, have a long-term but hard to quantify impact on theexchange rate. The narrowing of the US trade deficit (also vs. the EU)subsequently to the crisis is one more factor speaking in favor of the UScurrency. We expect the US current account to remain narrower than priorto the crisis, which should also support the dollar.

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EURUSD TB US vs. EU (rhs, inverted) Source: Bloomberg, Erste Group Research

In principle, a trade balance deficit should exert weakening pressure on thecurrency per se (there is less demand for domestic goods abroad than viceversa, hence less demand for dollars to pay for them). However, thedollars status as a reserve currency probably more than offsets this.Indeed, dollar holdings for currency reserve purposes have remained quitestable throughout the last decade (at least the ones officially declared asshown in the following chart), and the euro only marginally caught up as thesecond reserve currency. Indeed, it is estimated that the interest raterequired to hold dollars is 60BPs lower due to the dollar being a reservecurrency

1, so that even remarkably low yields (treasuries have been the

best performing asset in 2011, according to Bloomberg) might suffice tokeep demand for dollars stable.

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Share of USD in allocated Reserve currencies

Share of EUR in allocated reserve currencies Source: IMF, Erste Group Research

This also reinforces the argument that the dollar should, in principle be evenstronger than predicted by the interest rate differential except for fears ofFed easing. However, as we have argued, we expect the ECB tocompensate for this in 2012, so that overall we expect the EURUSDexchange rate to range closely to its fair value of 1.25 in 2012.

1F.C. Warnock, V.C. Warnock, International Capital Flows and U.S. Interest Rates, Federal

Reserve System International Finance Discussion Papers


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Technical outlook

The current rebound may continue for some time and a further rise toEURUSD 1.31 seems likely. MACD is posting a positive divergence andmight trigger the signal-line soon. Moreover, short-term sentiment turnedvery bearish recently. Following this technical bounce, we believe that theeuro-bears are most likely to strike again, as the overall technical biasremains clearly bearish. The medium- and long-term downtrends are stillintact. The recent break of the 200d-Moving Average, a highly negative RSIreading, bearish CoT readings, as well as most sentiment indicators supportour bearish view. A sell the rallies approach is advisable.

Although the central topic of conversation in 2011 used to be discussionsabout the stability of the Monetary Union, price action held up surprisingly

well. Therefore, we believe that trend acceleration might lead to a 1y low at1.188 (low June 2010). This should be the final leg of the downtrend and avery solid support level. Afterwards, we envisage 1.26 as a major target onthe upside.

Analyst

Ronald [email protected]


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FORECASTS

current Mar 12 Jun.12 Sep.12 Dec 12

EURUSD 1.30 1.30 1.25 1.25 1.25

Interest rates current Mar 12 Jun.12 Sep.12 Dec 12

EZB MRR 1.00 0.50 0.50 0.50 0.50

3M Euribor 1.33 0.90 0.70 0.70 0.70

Germany 2Y 0.18 0.30 0.35 0.40 0.45

Germany 5Y 0.82 1.00 1.10 1.25 1.40

Germany 10Y 1.92 2.10 2.15 2.25 2.40

current Mar 12 Jun.12 Sep.12 Dec 12

Fed Funds Target Rate 0.25 0.25 0.25 0.25 0.25

3M Libor 0.58 0.50 0.40 0.40 0.40

Yield 2Y 0.26 0.20 0.25 0.35 0.50

Yield 5Y 0.87 1.20 1.35 1.50 1.70

Yield 10Y 1.94 2.10 2.20 2.40 2.50 Source: Bloomberg, Datastream, Erste Group Research


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Contacts

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