EURUSD: Euro US Dollar Exchange Rate Forecast

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

A period of multi-week consolidation has now been broken to the topside with the market extending gains to fresh 2009 highs beyond 1.4340. The break above 1.4340 confirms a medium-term higher low in place by 1.3750 and opens the next upside extension back towards a measured move objective into the 1.4900’s over the coming weeks. Back under 1.4205 would now be required at a minimum to relieve topside pressure and potentially negated bullish outlook.

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

Euro/US Dollar interest rate forecasts have become somewhat bearish, but recent FX market price action suggests the EURUSD will continue to trade off of risk sentiment in broader financial markets. Indeed, the historically strong correlation between interest rates and FX market price action faded quickly through the onset of the global financial crisis. Overnight Index Swaps predict that Euro and US Dollar interest rates will be roughly equal in 12 months’ time.

Such forecasts should be bearish for the Euro, which currently enjoys a 100 basis point yield advantage over its US counterpart. Yet we believe that these developments may have little impact on the Euro/US Dollar exchange rate. It will be far more important to monitor trends in the US S&P 500 and other key global risk sentiment indicators.

[B]Euro / US Dollar Valuation Forecast[/B]

The Euro has pushed deeper into overvalued territory and is now 3135 pips above is “fair”, PPP-implied exchange rate as risky assets continued to advance, weighing on the safety-linked US Dollar. From a fundamental stand-point, the foundation behind Euro strength seems shaky: the IMF is forecasting that the Euro Zone will stand apart from other industrial economies in seeing GDP continue to shrink through 2010, which likely means the Fed will lead the ECB in starting to raise interest rates once economic recovery begins in earnest. In fact, a look at overnight index swaps (see above) seems to be pricing in just that. Further, deflation is beginning to set in while the banking sector is yet to come to terms with an estimated $1.1 trillion in unrealized sub-prime related losses (again courtesy of the IMF), a hit that could be compounded by losses from default or devaluation in some of the newly-minted central European EU member states. That said, the sharp rally in equity markets that has punished the Dollar since March continues to make new highs despite increasing chatter about the move being over-extended, so timing a reversal is a decidedly difficult endeavor. On balance, the bias remains bearish with further EURUSD gains to be taken as a welcome opportunity to exploit a larger disparity in valuation once the downturn does begin to 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 Bloomberg. We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar.