The big news in the FX market last week was the ease with which EURUSD broke above a number of key resistance levels to close the European session within touching distance of 1.30 – the highest level for a month.
The question for investors to ask now is whether or not this level in EURUSD is justified and can sustained? To answer this we need to look at relative monetary policy at the ECB and the Fed, the political backdrop in the currency bloc and the macroeconomic data.
Looking at the political backdrop first, Greece is likely to receive its next tranche of bailout funds on Monday 26th November. This removes a cause of near-term anxiety for traders as it means that Greece is not going to default any time soon and can easily meet its next major EU 5 billion bond redemption payment due in mid-December. The EU budget negotiation may be pushed out to January 2013, but this is second tier data for the financial markets and as such the lack of a resolution did not have much impact on euro-based assets at the end of last week.
Spain comes to the fore this weekend with elections in Catalonia on Sunday 25th November. The Premier Arthur Mas called this snap election when the central government in Madrid refused to re-negotiate the process of internal transfers. Catalonia, one of the richest regions in Spain, ends up paying more to Madrid than it gets back in benefits. This has led to an increase in secessionist rhetoric from Mas who is calling the election a referendum on independence. However, the independence parties are lagging in the polls with only two days to go, and they are unlikely to steal victory at this late stage. The Spanish people are expected to vote to keep the status quo. While this election by itself does not make Spain any more or less solvent, it removes a complication for the country as it continues to evade requesting financial aid. As we have said in previous research notes, we don’t expect Madrid to request aid this year as its bond yields have continued to fall (the 10-year yield fell 30 basis points last week) and it has easily sold debt at all maturities in recent auctions. Thus, the political back-drop, at least in the near-term, is showing signs of stabilisation into year-end, which could help the euro to rally in the medium-term.
What about interest rate differentials, a key driver of FX markets? The rate spread between Germany (as a benchmark for the EU) and the US has traded sideways and not kept pace with the spike higher in EURUSD, as you can see in the chart below. However, the Fed has sounded more dovish than the ECB of late. While the ECB remains ready to buy Spanish debt if it needs to, it is not expanding its monetary base and will sterilise all purchases made by its OMT programme. In contrast, Fed Governor Bernanke said in a speech last week that the Fed would be willing to extend monetary support if the economy starts to flag. In the next few weeks the focus will be on how the Fed will deal with the end of Operation Twist, which expires at the end of this year. The Fed may decide to increase QE3 to the tune of $85bn of long-term asset purchases to ensure there is no tightening effect from the end of Operation twist. Thus, at this juncture the Fed’s policy stance appears more accommodative than the ECB. This could be positive for EURUSD in two ways. Firstly, the rate differential may start to move in the Eurozone’s favour, which is euro positive. Secondly, the Fed’s commitment to QE3 helps to depress volatility, which is good for risky assets like the euro and can cause selling pressure on safe havens like the dollar.
The last thing to consider is the macro backdrop. Recently we have seen a chasm develop between the sentiment data and the real economic data. The PMI data in Europe remains very weak, but the GDP data was not as bad as the surveys suggest. There were some good signs from Germany. Strong exports in Q3, they expanded by 1.4% on the quarter more than the 1% expected, helped to support Q3 GDP. Also, the IFO index, Germany’s most important business sentiment survey, beat expectations this month. Stronger confidence levels were reported for exports demand from China, which is good news for an export-based economy like Germany’s.
Overall, the break above 1.2805 – the 200-day sma – keeps us constructive on the outlook for EURUSD in the medium-term. We think that a break above 1.30 could be on the cards, but we would expect the 1.3175 level – the high from September – to be a major stumbling bloc. The risk to this view is a flare up in sovereign concerns and a spike in Spanish bond yields. However, in the absence of a major risk-off event the stabilisation in the political backdrop combined with a dovish Fed could help EURUSD to drift higher in the coming weeks.