[B]Euro/US Dollar Monthly Technical Forecast[/B]
After a 3 week advance, the EURUSD should resume its long term decline. To review; since 1.60, price has declined in a series of 1st and 2nd waves. Most recently, the rally from 1.2475 is wave ii of 3. As long as price is below 1.3740, anticipate a break below 1.2327 and much lower in wave iii of 3.
[B]
Euro/US Dollar Interest Rate Forecast[/B]
The correlation between the EUR/USD and interest rate outlook spread has started to strengthen. After the ECB cut rates to 1.25% the interest rate outlook for the Euro turned positive which has narrowed the spread between it and the dollar to -11 from -84. President Trichet following the rate decision signaled that next month could see the committee pause their easing policy which is a driving factor in the increased expectations. Although the spread is still showing a bearish signal, we could see it turn bullish as we approach the next policy decision. Indeed expectations for the U.S. don’t figure to rise with the economy showing continued weakness.
However, the ECB also forecasted that they would make a decision on taking quantitative easing measures which could be a weighing factor for the Euro and wouldn’t be reflected in the interest rate outlook. Therefore, traders shouldn’t assign significant weight to yield differentials when making trade decisions.
[B]
Euro/US Dollar Valuation Forecast[/B]
The Euro has been treading water above the 1.2450 level as oscillations in risk sentiment turn price action choppy. However, EURUSD remains substantially overvalued – indeed, the single currency is now the most expensive against the dollar among its major counterparts when compared to its “fair” exchange rate. The broad-based fundamental bias supports a bearish scenario, adding to downward pressure and suggesting that EURUSD has scope to make substantial inroads into the value differential in the period ahead.
[B]
What is Purchasing Power Parity?[/B]
One of the oldest and most basic fundamental approaches to determining the “fair” exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. For example, if a pencil costs €1 in Europe and $1.20 in the US, the “fair” EURUSD exchange rate should be 1.20. For our purposes, we will use the PPP values provided annually by the Organization for Economic Cooperation and Development (OECD). We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar. Currencies pairs that are undervalued against their PPP exchange rate have the size of the value gap denoted in [B][U]RED[/U][/B], while those that are overvalued are denoted in [B][U]GREEN[/U][/B].