On 23rd March 2020, at the height of the COVID-19 market panic, the euro plunged to a low of 1.0636 against the dollar. A little more than four months later, the single currency sits more than 10% higher after reaching a high of $1.1781 yesterday. Most notably, we’ve seen a ~4% gain in the past two weeks. The question we are all asking now is, how much higher can the euro go?
There are two angles from which we approach this type of analysis:
- Macro Factors – Since early 2018, the euro has been trading at a significant discount to its ‘fair value’. There are several different ways of determining what ‘fair value’ is but based on our PPP model which incorporates both producer and consumer price measures of inflation, we estimate fair value to be $1.28 – $1.30. If the current discount is no longer warranted and therefore unwound, the $1.28 – $1.30 zone would be an obvious target.
- Market Technicals – Looking at the chart below, EURUSD is testing the top of the downward trend that began in 2008 at $1.60. A sustained break here would be very seen by technical analysts as very significant and fuel expectation of further gains in the weeks and months ahead. An obvious first target would be the $1.2500/50 area that capped the rally back in 2017/18 although, from a multi-year perspective, there would be room for significantly further gains towards $1.40.
Chart I: EURUSD Technical Picture
Having read various commentaries in recent weeks from many different analysts, there suddenly seems to be an overwhelming perception that the dollar will continue to weaken in the months ahead. This bias isn’t uncommon, particularly in the wake of a move like we’ve witnessed in recent weeks, but after such a long period of low volatility, it certainly gets us thinking about what might unfold in the coming weeks/months.
The main factors cited for a weaker dollar are:
- The US COVID situation continues to look relatively bleak – but not bleak enough to cause widespread panic in global markets (which we’d expect to result in a stronger dollar). Instead, things are just grim enough to warrant additional easing from the Fed and a delay the economic recovery.
- Political uncertainty – There is no doubt that Trump’s fiscal policies have been positive for the dollar over the past four years. We’re not suggesting that a Biden victory (which is now a clear favourite with the bookies) should be a negative for the currency, it could be argued that it would remove the Trump tail risk, but at the very least, it creates some uncertainty which markets don’t usually react positively to.
- Central Bank intervention/rebalancing – there has been evidence of Central Banks, particularly in Asia, rebalancing their portfolios which have generated demand for EUR, AUD, CAD and GBP. If the global outlook continues to improve, this trend will likely continue in the coming months/years.
Whilst we acknowledge all the above, we also note a couple of important factors that could still be bullish for the dollar / bearish for the euro:
- Yield / Carry – While the interest rate differential between the dollar and the euro has narrowed considerably in recent months, the dollar still has a significant advantage from a carry perspective making it more attractive for investors to hold.
- The Dollar’s safe-haven status – While some may argue that this factor is starting to diminish, the dollar is still the reserve currency of the world and the one investors flock to during times of crisis. If panic surrounding a second wave of COVID were to set in, it seems inevitable that the dollar would be the main beneficiary in the currency markets.
- Market positioning – According to the most recent CFTC data, investors have only been more bullish on the euro at one point in history (that was back in early 2018 before the euro fell by more than 15% over the proceeding 12 months). We see this level of positioning as a strong contrarian indicator (i.e. if the speculative market is heavily long EUR, there is a risk that investors will become squeezed on any dips causing a mass unwinding of positions).
- Technicals – as highlighted previously on the chart above, EURUSD is yet to break the downward trend dating back to 2008. While this remains the case and as the pair starts to become ‘overbought’ there is a clear risk back towards the 1.05 – 1.10 lows in the months ahead.
Chart 2: EUR Positioning
The conclusion that we draw from all this is that while there is certainly scope for a weaker dollar going forward, we don’t see it being the foregone conclusion that it may appear from an initial glance at the recent price action and numerous market commentaries. Either way, we’re at a key juncture. With implied volatility still surprisingly low, this could be the perfect time for clients to add optionality to their hedging portfolios to provide protection against an extreme market move.
Author: Marc Cogliatti