A parity call for the EUR/USD

A parity call for the EUR/USD

The Euro looks set to reach parity with the U.S. dollar for the first time since December 2002. There are a number of separate reasons why the U.S. dollar, broadly measured by the U.S. dollar index, has been strengthening while the Euro has been weakening. This article will aim to give a brief explanation as to these reasons and why a parity bet in the coming months is a decent probability.

The image below shows the U.S. dollar index which has strengthened +10.6% since it’s May 2016 low of 91.919. During this time the economic data for the U.S. economy has continued to show solid improvement, along with rising inflation expectations following president-elect Donald Trump’s victory. Combining these factors together it suggests the Federal Reserve may need to hike rates faster than previously anticipated.

In 2016 non-farm payrolls have averaged 180,000 new jobs each month, well above the 100,000 level that is estimated to keep the unemployment rate stable when factoring in population growth.


While we can see there has recently been a slowing of these gains in the jobs market, it’s not necessarily a troubling sign. This is as a result of a tighter labour market. In November the unemployment rate declined to 4.6% from 4.9%, with the current estimate of full unemployment said to be modestly below 5%. Once unemployment is below this rate expectations are for higher wages to lead to inflation and therefore require higher interest rates. The next chart below shows the unemployment rate which has declined significantly to now be at the lowest levels since August 2007.

Over this same time period as we see the labour market tighten, we are also seeing further evidence of wage pressures. Measured by the Atlanta Fed’s Wage Growth Tracker, hourly wages increased by +3.9% in October back to levels not seen since the beginning of 2008.

Another very important indicator to watch is inflation expectations, implied by the five-year breakeven rate. This rate is the difference between five year U.S. government bond yields and those on treasury inflation protected securities, for which the principal amount is adjusted for inflation. The difference between these two rates is then the market implied inflation expectations. Prior to the November 8th election this rate was +1.578% which has now increased to +1.835% on Friday shown on the next chart.

Inflation expectations are a very important factor in actual inflation, the reason being if you expect prices to rise in the future you are more likely to spend today which causes actual inflation. It is a self-fulfilling prophecy and central banks place a heavy importance on ensuring inflation expectations are anchored to their target rates. As long as these expectations continue to rise then the U.S. dollar will continue to be supported as the market prices in the possibility of more than two rate hikes in 2017. Looking ahead into 2017 the next updated economic projections will be at the March 14-15th meeting which should provide enough time to examine the impact of these higher inflation expectations and a potential revision in the number of rate hikes. 

Over to the Euro side of this currency pair, we have the European Central Bank which currently has a deposit rate of -0.40%, meaning banks pay the central bank to hold their money. On top of this the central bank has also announced the extension of its currently quantitative easing program from March 2017 until “the end of December 2017, or beyond, if necessary”. Although these purchases will expand at a slightly slower rate than previously (€60 billion vs €80 billion) it does highlight the growing divergence between the FOMC & ECB.

Data from the Euro-zone has recently stabilised following a pessimistic outlook 6-12 months earlier. The unemployment rate has moved modestly lower at 9.8% and core inflation is no longer declining and remains stable at 0.8%. GDP growth also remains flat, yet stable at 1.7% on an annualised basis compared with the negative readings back in 2013 shown below.

While this is an encouraging sign, there is not yet enough traction in the data to suggest the ECB should withdraw stimulus anytime soon, and therefore as the FOMC continues to raise rates the divergence between the two banks will only widen.

Another key reason the Euro has been weak is due to political reasons. There have been many grabbing headlines over the past few months as the markets assess the negative impacts from the upcoming Brexit negotiations, a failed Italian referendum that saw PM Matteo Renzi resign, an ongoing refugee crisis as well as the rise of populist Euro-sceptic parties that pose a threat in upcoming elections in France & Germany.

The final chart below shows the EUR/USD from a technical standpoint. There has been a clear rejection following a push higher to test a key resistance zone between 1.08 and 1.09 marked by previous lows in 2016 as well as the 50-day moving average and both the 50 & 61.8% Fibonacci retracement levels. This rejection suggests there is strong selling pressure above current levels.

The price has now quickly moved lower to once again test support between 1.0460 and 1.0500, marked by prior lows over the past two-years. The heavily oversold nature of momentum indicators coupled with the price at noted support suggests the increased risk of a pause or bounce from current levels. At this stage given both the dominant and intermediate trends remain down, any corrective bounces higher should provide good opportunities to enter short positions.

 

In summary there are a number of various factors as to why the Euro is weakening and the U.S. dollar is strengthening. The biggest factor among these is likely to remain the divergence between the monetary policies of both the FOMC & ECB. Until we see a weakening or reversal in this divergence, a parity bet on the EUR/USD in the coming months remains highly probable. 

Sources: Rivkin, RivkinTrader, Federal Reserve of Atlanta, TradingEconomics.com

This article was written by James Woods - Global Investment Analyst, Rivkin Securities Pty Ltd. Enquiries can be made via james.woods@rivkin.com.au or by phoning +612 8302 3600.

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This article contains information about foreign exchange contracts, which are considered complex financial products. Please click here to read ASIC's foreign exchange trading article before considering an investment in foreign exchange contracts. 
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