Is EURUSD finally getting ready for its 'big breakout´?
- EURUSD is now at the bottom of its two-year range
- A breakout would probably take the pair far below parity
- The consensus view of stronger USD rests on assumptions that could be wrong
By Juhani Huopainen
EURUSD has been trading in a relatively narrow range of 1.05-1.15 since the beginning of 2015. The previous large move in the pair happened in 2014, when it tumbled from a high of 1.40 to an eventual low slightly below 1.05.
In January 2016 I wrote that one of the big themes of the year could be EURUSD’s breakout. If I’m lucky, my prediction could still turn out right. I believe that EURUSD has been trolling us for far too long now – two years without a proper trend is very rare.
The last time we saw such a narrow range was in 2000-2002. The backdrop was eerily similar. The US economy had outperformed the European economy, thanks to the information technology boom. The USD had strengthened a lot on diverging interest rates and growth outlook. Then the dotcom bust came, stock prices collapsed and the outlook of the US and Europe converged. The economic recovery beginning from 2002 and continuing until mid-2008 was marked by EURUSD’s rally.
This time around, the US recovery has been stronger and more stable than Europe's so-called recovery. The US has already made one rate hike and is about to make a second one in December. The Trump presidency is expected to introduce growth-boosting tax cuts and increased fiscal spending, which have increased inflation expectations and opened up the possibility of more rate hikes in the coming years.
Meanwhile, the European Central Bank is expected to extend its asset purchase programme by six months and refrain from hiking rates at least in 2017. The rate differential is already very wide, and is expected to widen further.
On the other hand, the market knows all of the above. Much of it is discounted already. The potential surprises are always to the other direction of the consensus view.
I will now review the technical and macro charts and then discuss what could go wrong with the consensus view.
The very long EURUSD-chart does not provide any clear hints. The spot rate is close to an apparent long-term trendline, but charting nominal exchange rates over so long timeframes is usually not a good idea.
A collection of three different views of USD. The nominal broad trade-weighted index is approaching highs seen right after the 2000 boom. That could be a warning sign that a potential top is approaching. But the narrower, major currencies-index and the real broad trade-weighted index are not nearly as high.
While a stronger USD has in the recent past often ended up leading to a recession, the weakening of the USD has usually started well after the recession is over. It makes sense it takes time for the Federal Reserve to ease policy and for the interest rate differentials to move away from favouring the USD.
The ten-year US bond yields are much higher than in Germany - the euro area's benchmark for the risk-free yield. In fact, the yield differential is now larger than it was in 1999. Notice how the yield differential bottomed in 1999 and then rose to zero in 2002, but the EURUSD didn't start moving higher until 2002.
This suggests the EURUSD has more downside left, and even if the interest rate differential begins to narrow, it would not necessarily lift the EURUSD any time soon.
Inflation expectations have risen both for the euro area and the US, but the expectations are much higher for US. Especially the core prices seem much stronger in US. The European Central Bank seems to be aware of this and that is why it is prepared to run nominally easy monetary policy for a longer time.
Euro area inflation expectations now at 1.65 percent....
...while US inflation expectations are above two percent.
A comparison of the EURUSD bottom in 2000-2002 and the current EURUSD range in 2015-2016:
The current 2015-2016 range is horizontal.
A breakout from the 1.05-1.15 range would have a naive technical target of 0.1 from the breakout – either 1.25 in case of a break higher or 0.95 in case of a break lower.
The hourly candlestick chart shows how EURUSD's downside momentum has been decreasing as the dreaded 1.05-level has been reached. The pair might very well begin trading in a horizontal range of 1.0550-1.0650 for a while. Breaking the 1.05-level would probably be violent, as the area below it is probably full of sell-stop orders and option orders.
Given Europe's list of political risks and the most probable path of monetary and economic policy during the next two years, an eventual breakout to the downside is what one should expect now. But thinking what could go wrong with that view could help to avoid costly mistakes and react correctly to shifting situations.
Just like many other election promises, the tax cuts and spending-story might also become something much smaller than what the consensus currently believes. What if Trump changes his mind and does little, if anything? Or what if the US congress won't accept tax cuts or Trump's spending increases because it is worried about the high level of debt and the possibility of the next cyclical downturn being close already? This could slow the economy, lower inflation expectations and return the Federal Reserve to a slower rate hiking path – and keep EURUSD in the range.
Maybe the US being so close to full employment and full capacity means it cannot grow much faster, and the apparent differential between the US and the euro area begins to be perceived as not real? If US inflation increases, but real growth remains the same as in the euro area, maybe the USD would not be the darling of asset flows?
What if the European Central Bank cannot find a common will to extend the asset purchase programme by six months, and first says "we'll look into it in January", then decides "three months should be enough" and begins tapering around the summer? Perhaps the weaker EUR will be enough easing in the minds of the ECB's more hawkish voting members, and approaching elections might push some of them to resist easing because it would be seen by the "populists" (correctly) as stealth support for the crisis countries?
We should remember the big picture and see the range of the past two years as a rare anomaly. We should expect higher volatility and not be surprised by it when it eventually comes. But is not far-fetched that EURUSD could troll us for a bit longer.
– Edited by Clare MacCarthy
Juhani Huopainen is a blogger and a macro analyst at MoreLiver’s Daily