Since the middle of August, being long Euros and short US dollars has one of the best trades in the currency market. In less than 3 months, the EUR/USD climbed from a low of 1.3361 to a high of 1.4731 this morning. Critical resistance levels have been broken on a near daily basis and now that the currency pair is trading well above the psychologically significant level of 1.45, it will be clear sailing up to 1.50.
[B]Dollar Bearish News: As If It Couldn’t Get Worse[/B]
There are many reasons why the US dollar has been weakening and they ultimately center on interest rates. Over the past 12 months, the US Federal Reserve is the only central bank to lower interest rates, even the BoJ raised rates back in February. Therefore it is not a coincidence that the latest burst upwards in the EUR/USD began when the Federal Reserve surprised the market with a discount rate cut to 5.75 percent on August 17. In fact as indicated by the chart below, that was the actual day that the EUR/USD began to turn higher and since then it hasn’t looked back. This strength was further exacerbated by the continual hawkishness of the European Central Bank who could very well increase interest rates over the next few months. This dynamic has been driving the EUR/USD higher for the past 3 months, but when everyone thought that things could not get worse, China came out and suggested that they could diversify their mammoth amount of reserves out of US dollars. According to China’s National People’s Congress Cheng Siwei, the Asian Giant “favors stronger currencies over weaker ones and will adjust according.” As the world’s largest holder of foreign exchange reserves and a big owner of US treasuries, China has the ability to move markets. Interestingly enough Cheng Siwei was the same official that warned of stock market bubble in the beginning of the year and his comments triggered a 300 point drop in the Shanghai Index over the course of 4 trading sessions. Even though Cheng tried to take back his comments shortly afterwards by saying that this does not mean they will buy more Euros, the damage was done.
[B]EURUSD: Strength Will End When ECB Cries Uncle[/B]
Both fundamentally and technically, we continue to believe that there the EURUSD will reach 1.50 and now it is looking like this could happen sooner rather than later. Not only are traders still concerned about the financial sector and believe that the Federal Reserve could lower interest rates once again to restore confidence in banks, but the ECB could also increase interest rates now that we have seen a rate hike from both Sweden and Australia. Yesterday’s interest rate hike by Australia indicates that major central banks are not afraid to raise rates in the current market environment. With inflation well above their 2 percent target and oil prices continuing to climb higher, the ECB has no choice but to be hawkish. Having been so proactive with injecting liquidity in the midst of the credit crunch in August, the ECB may choose to be proactive again with combating inflation. They need a strong Euro to offset the rising the cost of oil which is why we haven’t heard one word of complaint from Trichet even though the Euro has risen above 1.45. An interest rate hike by the ECB or hawkish comments on Thursday will only exacerbate the strength in Euro. We do not rule out the return of the words “strong vigilance” towards inflation, which would signal that rates could be raised in the very near future.
Also, for the first time since 2001, Euro rates on a 2 year maturity have increased above US rates for the same tenor. The last time this happened, the EUR/USD rose from 0.90 up to 1.00 within 12 months and then to 1.35 over the next 3.5 years. For this reason, we expect to see the EUR/USD rise to at least 1.50. Technically, the EUR/USD has already exceeded the 161.8 percent extension of 1.4015-1.4349/1.4125 at 1.4666. At this point, we expect a small 4th wave correction that could reach 1.4434 before a new high. The last chart illustrates our expected move for the EUR/USD on both a technical and fundamental basis. US dollar weakness will only end when the ECB cries uncle or the Fed turns surprisingly hawkish.
By Kathy Lien, Chief Strategist of DailyFX.com