History may repeat itself, as chart signals EURUSD is on the way down
- A pattern from 1997-1999 may be about to repeat itself for EURUSD
- EURUSD could decline even if rate differentials move in its favour
- European election risk looks like a potential driver for the currency pair
- Traders have noticed the recent low inflation reading and dovish ECB rhetoric
The demise of the euro has been predicted by many analysts over recent times, usually centred around EURUSD breaking through parity and then gathering momentum en route to its 2001 low at around 0.8200. But for some time, the cross has been in a sideways pattern, defying bulls and bears alike. Many trend-following traders put have it in the too hard basket and looked elsewhere.
Not as easily put off, the analysts at CitiFX, the world’s largest FX trader, have concluded the recent chart pattern looks remarkably similar to the 1997-1999 formation, suggesting, if history repeats, this is an excellent selling opportunity in EURUSD. Citi sold at 1.09 and recommended clients join them. This chart illustrates how they see the trade evolving over the coming months.
The team at Citi don’t confine themselves to technical analysis. Having spotted what looks like a repeating pattern they go back and have a look at what the prevailing “fundamentals” were at the earlier date. You would have thought they discovered a widening interest rate differential in favour of the USD which, in turn, was driving EURUSD lower.
In fact the opposite was the case, because in late 1999 the European Central Bank had found itself behind the curve and reversed course, tightening monetary policy. At the same time the Federal Reserve was on its own path to higher rates.
Today we see calls for the ECB to reverse course while the Fed is well under way with its rate “normalisation” strategy.
The takeaway from the fundamental comparison is that the policy change by the ECB sent the EURUSD down, not up as might have been expected.
Is this a case of deja vu then ?
At this stage of proceedings the ECB is giving no hints they intend to change course any time soon. The bank’s chief economist and governing council member Peter Praet said in a recent interview that he is more optimistic about the economic outlook, but on going expansionary monetary policy was needed to achieve the inflation target.“If the markets were to pick up any change in communication about the deposit rate” he said” it would have the potential to change the policy stance, and we do not want that to happen right now”.
Other governing council members, including President Mario Draghi, are singing from the same song sheet, letting the markets know they see no sign of much improvement in the outlook for core inflation. In fact, the minutes of the council’s March meeting show some concern about whether the central bank’s current inflation assumptions are still valid. As the following chart shows, core inflation dropped to an annual rate of 0.7% last month, raising doubts about the 1.1% average expected for 2017
ECB inflation chart
Market based inflation expectations data is not moving in the right direction either, with the 5 year/5 year forward break even rate drifting down. The jury is still out on how much impact the recent oil price decline is having on this calculation but the ECB won’t be giving it the benefit of the doubt.
5 year/5 year rates chart
Source: Goldman Sachs, J B Were
Traders have taken note of the recent low inflation reading and the ECB’s dovish rhetoric. The probability of a rate hike this year has dropped from over 50% to around 15%. Clearly then, short dated rate differentials will be working against EURUSD for a while yet.
Eonia rate hike probability chart
When there are lulls in the economic data calendar and the political situation across the Eurozone is calm, EURUSD traders often take their cue from the 10-year US Treasury versus German bund yield spread. At over 2% it remains at its highest level since peaking just under that mark in 1999. But, as CitiFX points out, despite the spread in favour of the US then narrowing for the next three years, EURUSD declined with it. Theoretically it should have gone up.
A similar situation may be developing now. The main impact of the ECB’s bond buying program is on the short to medium part of the German bund curve while longer term rates drift up as shown in the following chart. The curve is changing shape. Meanwhile yields in the US bond market remain stuck in a range. So, as in 1999, the 10-year spread may have peaked and, while counterintuitive, history suggests this will not necessarily benefit the euro.
German Bund yields
Source: Allanz Global Markets
If EURUSD is going to repeat the 1999 chart pattern and sell off from here, even as medium term rate differentials move in its favour, what outside factor will be the driving force? The obvious one is political risk, with elections in both France and Germany on the agenda. Others on Trading Floor are better qualified than me to discuss the possible scenarios in that arena. Instead, I will leave readers to ponder the chart from CitiFX that suggests, for whatever reason, history may be about to repeat for EURUSD.
My trading forecast on EURUSD is based on last week’s striking “Outside Reversal Week” and my Elliott Wave analysis (see weekly chart below)
Weekly EURUSD Chart
For more on forex, click here.
– Edited by Robert Ryan
Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.