Euro US Dollar Exchange Rate Forecast

[B]Euro / US Dollar Monthly Technical Forecast[/B]

Sentiment and technical considerations favor a top forming now. On the sentiment side, the risk reversal rate (call option volatility - put option volatility) on 25 delta 3 month EURUSD options is the highest in at least 6 years (I have data that extends only to 2003) and speculators (as reported from the CFTC through COT numbers) are net short US dollars for the first time since May 2008 (near a former USD bottom). Technically, the decline from 1.4723 counts as an impulse (5 waves) and the rally from 1.2454 is in 3 waves (to this point). RSI is divergent and in overbought territory. The risk to going short now against 1.4723 is that the rally from 1.2454 extends into 5 waves and above 1.4723 in order to complete a larger correction from 1.2327. In this case, there is measured resistance from 1.4791 to 1.4850.

[B]Euro / US Dollar Interest Rate Forecast[/B]

Although the main driver of EUR/USD price action has been risk sentiment, it is curious how the pair has rebounded to more closely track the differential in interest rate expectations. The ECB lowering their benchmark rate to a record low 1.00% from 1.25% helped closed the gap as it widened the spread to -11 from -5. The central bank announcing that it will begin on quantitative easing by buying “covered bonds “has eased expectations that they may ultimately lower rates to near zero following the Fed’s lead.

There has been much debate in the public forum from committee members as to whether 1.00% represents the bottom for interest rates and whether the €60 billion in bond purchases is the limit. Unemployment reaching to an almost decade high of 9.2% and inflation falling to 0.6% have caused enough concern that it will keep open the possibility of future action which could be a weighing factor on the pair. Additionally, expectations that the U.S. will emerge first from the downturn could see flows return to the dollar and lift against currencies with lagging economies like the Euro.

Euro / US Dollar Valuation Forecast

[B]EURUSD Valuation Forecast: Bearish[/B]

The Euro remains the most substantially overvalued currency against the US Dollar, trading over three thousand pips above its “fair” exchange rate. Although EURUSD has seen decisive gains on the back of a rebound in risk appetite beginning in early March, the long-term fundamental picture is supportive of a broadly bearish scenario: a smaller-scale fiscal effort and a deliberately slow approach to monetary easing suggest the Euro Zone’s economic recovery will lag behind that of the US, fueling expectations that the Fed will be first to raise interest rates and boost demand for greenback. Still, the pair’s current momentum cannot be ignored and it is possible that prices could head deeper into overvalued territory before a correction materializes. The deepening disparity is ultimately advantageous, offering sellers a better entry point once a correction does materialize.

[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.