Why isn’t the EUR/USD lower?

Why is EURUSD still trading at 1.3400 when almost everyone agrees that it should be trading around 1.20? Apparently there are good reasons for that and we advise our clients to stay extremely cautious ahead of a usually thin December (more details on Strategy). The market theme remained the same last week. Traders are keeping their focus on the stockmarkets and Eurozone bond spreads performance and any data releases are used to either reinforce the daily trend or just give a better price to go short or long accordingly.

The most important news was that Germany on last Wednesday struggled to sell its new 10 year bond and actually ended up having the lowest subscription since the introduction of the EUR, indicating that investors are at last starting to feel uneasy with Germany as well. Italian yields stayed above 7% despite continued ECB intervention, while Belgium was dragged into the eye of the storm following the news on Dexia and a downgrade to AA on Friday. The EUR was under pressure for the whole week and EURUSD posted a low of 1.3210 on Friday before correcting towards the mid 1.33’s on rumors of excluding the private sector involvement from any new bailout and short covering ahead of the weekend. The weekend story of a rumored 600 billion IMF rescue fund for Italy has helped the EURUSD test the offers at 1.4400.

Data & Week Ahead
 
We still expect that FX traders will continue watching the bond spreads for direction this week especially with upcoming auctions from Belgium, France and Spain. Although data are not so important in the current environment, Fridays NFP (non-farm payrolls) report should never be ignored. Expectations are rather optimistic for an addition of 160k payrolls in November while the US consumer confidence on Tuesday is also expected to rebound to its September levels. In the Eurozone the data calendar is packed with PMI’s and confidence indicators and we should expect further weakness to dominate. In the UK we will stay focused on Tuesday’s Autumn statement from Chancellor Osborne expecting a rather reassuring speech on the deficit reduction plans and hope that that they will not be undermined by the worsening outlook on growth.

Strategy
 
Surprisingly and despite the widespread debt crisis and the worsening outlook for Europe, the EURUSD remains still above the year lows of 1.2873 posted on the 10th of January. This has come as a big surprise to many market participants and prominent analysts that have been calling for sub 1.20 levels. In our view there are a number of factors that have so far been able to support the EURUSD.

On flow terms the fact that Germany has so far remained able to attract the most of the outflow from the southern European nations (as is clearly evident on the persistent widening of peripheral against German spreads) has been a dominant factor. However, after last week’s auction even this safe haven will start being questioned. If this is a start of a new trend then we will be expecting more EUR weakness ahead. On the other hand the USD remains on a clear downtrend for the last decade (the USD index has lost more than 30% since 2000) and it is surprisingly lower for the year as well (around 3%). The reasons are obviously not short term and will not change easily. The FED remains ultra dovish, preparing for a third round of QE and vowing to keep interest rates at 0% until 2013 at least.

The AAA rating is not the US’s Holy Grail anymore while the huge twin deficits are gradually getting out of control. The 2011 might prove to be the ultimate test for the EURUSD but ahead of the persisting uncertainty and EU’s inability to provide a backstop to the debt crisis we cannot exclude any outcome ahead. For the next week and December we are inclined to remain extremely cautious as thin liquidity can create violent reactions to any news. Technically on the short term we have to remain sellers on spikes with a stop loss above the 1.3625 latest peak but will keep the size of our positions small.