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Why on Earth is EURUSD so Strong?

20 Years ago | March 13, 2014 11/27/21, 12:00 AM

The EURUSD has started 2014 the way it left off 2013, confounding the consensus view that it would trade lower this year. While this year is still young, being short EURUSD has been the pain trade for the forex market as it trades close to 1.40 vs. a consensus forecast that it would trade to around 1.25 in 2014. Why has the EURUSD been so strong? I will explain why the EURUSD is strong and what it would take to change direction.

Market Positioning

The most logical explanation is the market was positioned short on the view that the EURUSD would weaken as the Fed tapered its bond purchases while other central banks (e.g. ECB, BoJ) eased monetary policy. So far the Fed has fulfilled expectations by starting its tapering process but harsh U.S. winter weather has seen bond yields dip, which has dampened interest rate support for the dollar. The ECB (and BoJ), meanwhile, has disappointed by not easing policy. This was highlighted in the latest ECB meeting where Draghi gave a green light to buy EURUSD by showing little concern over the deflation risk, instead focusing on the medium-term forecasts and downplaying the impact of a stronger currency on inflation (10% appreciation of the EURUSD equates to a 0.4-0.5% drop in inflation). This forced shorts to exit positions and has pushed EURUSD towards 1.40. While 1.40 is a key psychological obstacle, I have seen some calling for 1.45 as the point of pain for the ECB.

 

Why is the EURUSD Bid?

The answer may be as simple as supply and demand. I wrote an article one month ago entitled, Why is the EURUSD Bid? http://www.tradersadvocate.com/member_contents/index/120

 In it I quoted a Reuters article that said:

The balance sheet of the European Central Bank has fallen by €553bn over the past year as banks repay money that they no longer want, either because ECB funds are too costly in a near-deflationary world or because lenders are being compelled by regulators to shrink their books.

This is "passive tightening" or "endogenous tapering". The ECB balance sheet has plummeted to 23pc of eurozone GDP from a peak of 32pc in July 2012….

Add in the flow of funds into peripheral bonds (e.g.; Italy, Spain, etc) that have seen yields fall sharply and it may just be a matter of supply and demand.

Confounding EURUSD

The following is a post on the GVIForex forum from a professional trader that sums up the current frustration being experienced by EUR bears.

A lot of EUR bearishness around- Soros, Martin Armstrong, 0 Hedge, etc, etc. It’s actually hard to find something written that’s EUR positive. Maybe this is the reality of a dehumanized market these days driven by momentum and other factors. I don't know. It is hard to read these pieces and then look at the screens and see just the opposite playing out though. It is even tougher to counter trade the move. There's virtually no pull backs and charts look like there's still substantial upside potential...

Add in the ability of the EUR to ignore the Ukraine crisis where in other times it would have suffered from any concerns involving Russia. Instead it has been firming rather than suffering from a flight to safety, suggesting there are other factors supporting the currency.

What Might Change the Picture?

The most obvious catalyst would be the ECB sending a signal by easing monetary policy, either by cutting interest rates or adding liquidity (e.g. quantitative easing). As noted, this was the market expectation coming into the year but the ECB, where policy seems to be driven more by the needs of Germany than the needs of the whole, has shown no signs of loosening its monetary grip. On the other side of the Atlantic, interest rate expectations will be a factor and a lot there depends on how far the U.S. economy snaps back from winter weakness. So, watch US data and interest rate expectations. Also watch the ECB, more what it does than what council members say about policy risks. In addition, keep an eye on the situation in Ukraine as it is causing some risk aversion although political events rarely have a long lasting market impact. From a trading perspective, watch EURUSD 1.40 as it will dictate whether the currency is seen in a 1.30-1.40 or higher 1.35-1.45 range.

 

Jay Meisler, founder

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