EUR/USD Conversion: Why Won't the EURUSD Hit Fresh Lows?

The euro remains in a holding pattern against the US dollar - why are markets more constructive towards the shared currency in early 2016?

The euro to dollar exchange rate has been caught in a sideways move since the shared currency staged an impressive rally at the start of December. 

Defining the range is the 1.10 line and the area of support can be seen between 1.07 and 1.08 - we have seen the EURUSD close outside of this range just once in 2016.

The key to breaking the log-jam argues Société Génerale’s Kit Juckes would be a return to life in the U.S Treasury market.

A move higher in yields would translate immediately into a fall in the EUR/USD pair it is argued. 

“We are back in a similar world to the one we saw before this year, when a 1% move in 2-year rates was associated with a 12-figure move in EUR/USD,” says Juckes in a recent client note.

According to this “super-simple measure” EUR/USD should reach parity if 2-year US rates moved to 2% (from a current level of 1.096).

In a note released on Tuesday, furthermore, he added:

“My Bund/Treasury-based EUR/USD model has now spent a month in a 1.08-1.10 range, and it will take higher Treasury yields to move us to, let alone through the bottom of that range." 

Those who thought that the higher-than-expected Non-Farm Payrolls result on Friday would cause a rise in yields, due to increased chances of the Fed hiking, were dissapointed as their response was marginal.

The worsening financial crisis in China combined with the global commodity crisis, now appear to be fuelling renewed U.S Treasury buying, keeping yields low (which move inversely to prices):

“We’re cautious of prematurely concluding the influence of the Chinese situation has ended and that Treasury’s will once again refocus on domestic fundamentals, if for no other reason than the muted response to Friday’s universally strong employment report,” wrote Ian Lungen, senior government bond strategist at CRT Capital.

But it is not only U.S Treasuries which are being used by investors as a safe-haven, German Bunds are too – and even more so following a cluster of recent positive releases from the country, the most noteworthy of which showed German House Prices returning finally to vaulted pre-crisis levels.

It’s no wonder the Juckes model is stuck in a range as global risk off is pushing up demand for both Treasury’s and Bunds at the same time.

Housing Leads the Eurozone Economy to Better Days

It seems the euro can also rely on its own economy for support at the start of 2016.

The single currency may be supported by green shoots which have been appearing in eurozone housing, as recently noted by researcher's at HSBC:

“Housing markets are firming in much of the eurozone.

“The combination of record low mortgage interest rates and better employment prospects are tempting prospective buyers to take the leap.

“Prices in Germany have now reached pre-crisis levels; whilst those in Spain are on the rise.”

This compares particularly well to U.S data, which recently saw U.S Existing Home Sales fall by -10.5% in November, however, this was predominantly put down to the delay caused by new “Know Before You Buy” Federal regulations, rather than a slowing of the underlying market.

Mosaic of Improvements 

An upturn in housing is part of a mosaic of small improvements, which taken together are building a compelling picture of renewal for the euro-area region, and providing underlying support for the euro.

another piece of the 'mosaic' is private sector lending, the achilles heel of the crisis, which has seen a rise, according to National Bank of Canada; providing, “encouraging signs that the European Central Bank’s aggressive policies are starting to bear fruit.”

NBoC say:

“Credit channels in the Eurozone are slowly being unblocked as evidenced by improving household credit and business loans, the latter even managing to grow on a year-on-year basis for the first time since 2012.

“So, unless inflation disappoints, the ECB may want to adopt a wait and see approach.”

If the ECB decides to hold back on its policy of increasing the money supply then we could well see an improvement in the euro as it is the threat of further interest rate cuts and quantitative easing that is the single biggest threat to the euro's value in 2016.

ECB Runs Out of Bonds to Buy

Quantitative easing is a loose term that also covers the ECB's purchase of private-sector bonds, by buying up bonds it is releasing cash and hoping to unblock the Eurozone economy.

During the crisis the covered bond market died but now appears to be recovering.

Parts of the market were stimulated artificially by the ECB when they started buying covered bonds in a pre-cursor to its QE programme.

However, there is now a marked rise in ‘non-eligible covered bonds’ – that is bonds not eligible for inclusion in the ECB's QE programme, according to covered bond specialist Joost Beaumont of ABN Amro - a sign that the wider market and the underlying mortgage market are healing. 

Fixed Income Analysts at Banca IMI appear to see little chance of Draghi increasing QE, simply because there is now such a limited supply of available bonds to buy, which places a supply ceiling on the governing council’s decisions:

“The market expectations that the ECB may decide in the first months of this year to step up monthly purchases of government bonds seem unrealistic by all accounts, given the serious constraint already imposed by the size of the German market.”

But, Inflation Could Yet Undermine the Euro

Whilst the slow-down in inflation in December was seen as a possible one-off, if it became a trend it could be the fly-in-the-ointment for the euro.

As Alex Lydall of Foenix Partners says, the December inflation miss could not be put down to the fall in oil alone, and this was of major concern, since a deflationary trend in core prices could be one of the factors leading to more action of some kind from the ECB, and potentially a devaluation of the euro:

“Despite relatively aggressive policy measures last month at his press conference, notably cutting the deposit rate and extendingQuantitative Easing, inflation woes are not easing for Draghi.

“Furthermore, the notable explanation of downward pressure from energy prices across the globe is easing off, seeing a substantialdrop in consecutive months from September through to November. 

“Taking this lessening effect of energy prices into consideration, Draghi will be hopeful of an uplift in the short term to avoid further pressure to extend monetary policy measures in early 2016.”

If the ECB feel that inflation remains dangerously low they make take further actions such as cutting interest rates and expanding quantitative easing, this could see the euro to dollar exchange rate break lower again and finally test the 1.0 level.