When studying a currency pair’s movement it is important to understand that all is based on simple supply-demand equilibrium. But the factors affect that reality continues to increase and it becomes difficult to know or what to expect about the future of a currency. In this article, we are going to try to understand some of the factors that influence EURUSD’s current and future movements and find a roadmap for investing in this currency.
Current Situation
- US Elections: Biden won the elections. It may not be over yet, Trump will probably use everything in his power to change the outcome through legal or maybe even illegal means but looks like he couldn’t find the help he needs from the Republican Party, and his actions cannot change the reality. In this Biden – Republican Senate environment, both Biden and subtly senate majority leader McConnell giving unity messages. This means, stimulus package talk may begin soon and without election worries, both sides will be more eager. But sure it will not be the same size as if the blue wave wins, but FED probably will make a move and close that gap. This outlook may put pressure on the dollar.
- US Economy: Current state of the economy shows signs of improvement both in the production and the jobs market. Last Friday employment numbers are off the chart and the fall of unemployment is not come from participation rate decrease as before. Permanent job losers data increase halted for the first time since the pandemic began, participation rate increase while unemployment drops to %6.9. We also see an increase in PMIs, Factory Orders, etc. But even if everything seems ok, Covid-19 numbers are changing for the worse. The US is the first country which increases daily cases by over 100.000 and because of the elections, Trump’s speeches, November may become the worst month.
- Eurozone Economy and ECB Decision: Europe’s current economic state is a little worse than the US. Even if the final PMI data shows an improvement, the overall outlook is weak. Inflation is at an all-time low, below zero and according to ECB, it may stay that way until early next year. Covid-19 cases increasing fast but it may not as fast as the US’s cases (except France) but a substantial amount. Covid-19 lockdowns are in effect and new ones are coming every day. All of this is forcing ECB’s hand and finally, in October’s meeting it was announced that they will reorganize bond-buying programs in December’s meeting.
Inflation
Inflation is the percentage price change of a selected goods basket for a certain time. An increase in inflation means a decrease in purchasing power. As for a country’s currency, means loss of value. So, if inflation decreases, currency value increases. When studying an exchange rate like EURUSD, we can look for the difference in the inflation rate.
In the chart, above we see Eurozone minus US consumer inflation and below that EURUSD. This year, Eurozone inflation fell to all-time lows, below zero while US CPI is holding above %1. This is pressuring EURUSD to the upside. The latest economic data coming from the US shows an increase in recovery while ECB expects that inflation continues to remain below zero for a few months. This mean upside pressure of EURUSD from inflation may remain in the near medium-term.
Inflation Expectations
We already discuss the reverse effect of inflation on EURUSD. Financial markets usually don’t look what already happened, but what can happen because when you invest in a security, you are investing in the future of that security. So it may be better to look for inflation expectation rather than the actual inflation to predict what may happen in the coming days to EURUSD.
Eurozone – US inflation expectation spread has a negative correlation as expected. But since the beginning of November, there was an upside move in both of them. In short term, we probably will see a correction on one or both of them. In medium-term, however, horizontal expectations continue and this means the 1.16-1,20 zone is still looking steady unless we saw new signs in the next two months.
Correlation between inflation expectations spread and EURUSD is undeniable, but is really this spread affect the EURUSD or the relation is or the opposite of it? Well, the answer is both. In econometrics, granger causality test is being used to determine which highly correlated variable cause the other one to change. In this case, it is a both way street. Both EURUSD and inflation expectations spread is affecting the other one over 99 percentage. This means:
- If EU-US inflation expectations spread decrease, EURUSD may face upward pressure.
- If EURUSD increase, Eurozone inflation expectations may skimmed.
That is why ECB doesn’t want EURUSD price above 1.20. Inflation and inflation expectations are already under pressure to the downside and if Euro appreciation increase even more this could cause more trouble for Eurozone. If price get close to 1.20 we can expect more aggressive moves from ECB.
Central Banks
At the beginning of the pandemic crisis, FED injected so much money by buying assets, and after that US congress agreed on a stimulus bill in April. ECB announced PEPP (pandemic emergency purchase programme) in March. But FED’s move was bigger and with the injection of more money than ECB gives EURUSD a push. But in summer ECB steadily close the gap.
Stimulus packages from governments and central banks increase money supply and inflation. As the supply began to increase related currency will lose some of its value, sometime immediately but mostly with delayed. As seen in this chart and inflation charts above that, the US was a lot more aggressive and this increased the inflation, the inflation expectations more and EURUSD, it caused an upward trend started from May, two months after the initial injection.
ECB is going to decide its move in December and also the US congress, FED. If ECB couldn’t match the FED and congress again this may mean over 1.20 EURUSD, otherwise, 1,16-1,20 consolidation period may continue a little while longer.
What are Derivative Markets Expecting
In the options market, 1 month implied volatility looks steady. It is not a perfect indicator but as discussed earlier, the market may want to see some signs from central banks and inflation, before a new trend emerges.
Speculative positions broke the uptrend in September and EURUSD did after that. EURUSD is clearly in consolidation period since August and net positions fell to negative side last week, for the first time since July. This may not be a negative thing for the EURUSD. If short positions increase while EURUSD move around 1,16-1,20 horizontally, above 1,20 price may trigger fast buying like in July which cause EURUSD to jump from 1,12 to 1,18 in one month. And downside move may become much slower and less risky because of less panic selling.
A Forward Indicator
10-year bond spread sometimes can be used as a forward indicator for EURUSD. There are a lot of variables that are affecting the exchange rates because of that it may not always work (like all of the technical or fundamental indicators) but for the last 5 years it usually gave good signals.
When a reverse trend develops in the spread chart, a couple of months later the same trend usually appears in EURUSD. After July spread began to fall again but is it a trend or not, isn’t clear yet.
Summary
- Inflation and inflation expectations are well anchored in Europe and inflation expectations spread with the US remains low but steady for the moment.
- FED, ECB, and US Congress are going to make important decisions in the next few months. If ECB can’t match the US stimulus package or the FED’s bond-buying speed as before, EURUSD’s risk to the upside is going to get higher. Because of EURUSD’s and EU-US inflation expectations spread are both way causality, this may create a chain reaction and a new EURUSD uptrend may form.
- But until there is a clear signal about these decisions, implied volatility may remain steady and EURUSD may continue to stay between 1.16-1.20 levels.
- Our forward indicator, however, sends a weak signal (for the time being) that downside risks of EURUSD rising for early 2021, which also is at the same time ECB’s expectations of negative inflation to end.
