A look at the EURUSD

By David Morrison  |  08/11/2018 15:49

The dollar has rallied from yesterday’s lows but remains under pressure as gridlock results from US mid-terms

Where next for the EURUSD? Fundamentally, we have the US Federal Reserve actively raising interest rates while reducing the size of its balance sheet, effectively unwinding quantitative easing. This has the effect of simultaneously boosting the attractiveness of the greenback relative to those countries with lower rates while cutting the supply of dollars available. Meanwhile, the European Central Bank (ECB) continues to add stimulus and keep its Minimum Bid Rate at zero. While the central bank has forecast that it will end its monthly bond purchase programme next month, it is unlikely to make the first tentative steps to raising rates until the we get into the third quarter of next year.

US/China trade war

Of course, the Trump administration wants a cheaper dollar to boost competitiveness. There’s a trade war going on with China and this is keeping a cap on the dollar. After all, in the absence of the recent tariff battle why wouldn’t investors favour the dollar? US GDP has roared ahead while we have sclerotic growth rates across the Euro zone. US unemployment is at a 49-year low, wage growth has picked up sharply while inflation is at or above the Fed’s 2% target, depending which measure you take. Trump’s tax cuts and regulatory reforms have contributed to this. While yesterday’s mid-terms may suggest there may not be much more fiscal stimulus forthcoming, the Federal Reserve has signalled that it is prepared to raise rates by 100 basis points between now and the end of next year. That can only boost the dollar’s attractiveness to investors.

Europe in trouble

Meanwhile, the Euro zone has some major problems with which to contend. At some stage the UK will be leaving the European Union (EU), deal or no deal. Meanwhile, the European Commission (EC) has rejected the Italian government’s budget proposals and has given the country until next week to come back with plans to slash its budget deficit. Neither side looks like backing down, raising the prospect that Italy gets hit with sanctions and fines – something which will only inflame tensions. All this comes on top of political upheaval across the EU. Even Germany facing fundamental challenges as it’s not too strong to say that Angela Merkel is now a lame-duck Chancellor.

Positive signs?

Now it could be that the EC and Italy manages to come up with some form of compromise. If not, then we should expect a sharp sell-off in Italian bonds which will put intolerable pressure on the country’s banking sector. This in turn will hurt other Euro zone members, particularly France, which have a large exposure to Italian debt. In this situation, we should expect the euro to decline sharply. On the dollar side of the equation, much now depends on whether there is some rapprochement between the US and China over the coming weeks. If there’s any likelihood of Trump and Xi Jinping agreeing to a side-meeting at this month’s G20 get-together in Buenos Aires, then this will be dollar-positive. But there’s a large gulf between the two leaders, particularly over US allegations that China is engaged in large-scale intellectual property theft. Even if the two men do get their heads together, there’s no guarantee that there will be a positive outcome.

A look at two charts

Several analysts have pointed to the formation of a ‘double-bottom’ for the EURUSD. This is typically positive suggesting that we see the euro break back and consolidate above 1.1500 before heading higher.



 
But stretching the chart out a bit suggests that the euro could be set to weaken further over the longer term. It may be a bit of a stretch, but that looks like an, admittedly messy, ‘head-and-shoulders’ to me. If so, and assuming the neckline is as I’ve drawn it (which is rather subjective), then assuming prices don’t break above the peak of the right shoulder, then there’s the prospect of a large decline in the euro to come. Of course, we could get both with short-term strength followed by long-term weakness. Much will depend on political news flow over the next few weeks. 


 
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