Could the euro be the next target for the FX market?

<p>The dollar is storming the FX market today and is the best performer, by far, out of the major currencies. The South African rand, Swedish […]</p>

The dollar is storming the FX market today and is the best performer, by far, out of the major currencies. The South African rand, Swedish Krona and New Zealand are the worst performers vs. the USD, while the emerging markets have also started to succumb to dollar strength.

The weakness in the EUR and GBP are hogging the headlines, GBP/USD is currently testing 1.2250, 130 pips lower so far today, and EURUSD is at a 2-month low at 1.1080. The driver appears to be Treasury yields. The 10-year US Treasury yield is at its highest level since June at 1.75%, this compares with Europe and the UK where bond yields have retreated today.

We think that the decline in EURUSD is potentially more interesting than GBPUSD, and we expect volatility in this pair to pick up significantly in the coming days and weeks.

Could EUR be the new GBP?

The EUR’s resilience in the face of dollar strength has been puzzling traders of late. In contrast to the pound’s capitulation to multi decade lows vs. the dollar, the euro has had a more moderate decline. But this could be about to change. Figure 1 below shows the 2-year US and 2-year German bond yield spread, which has reached a 10-year high.

Understanding the impact of yield spreads on currencies

This spread tends to move inversely to EURUSD, so as the spread widens, this should bode ill for EURUSD. Figure 2, shows the same yield spread and EURUSD, but only back as far as 2015. Back in Nov 2015, EURUSD was trading below 1.06, even though the spread between US and German 2-year yields was 138 basis points. Today the yield spread is 152 basis points, yet EURUSD is more than 400 pips higher! This suggests that EURUSD may have a lot fall further in the coming days and weeks.

Just how low can EURUSD go?

It is difficult to judge how far EURUSD will fall by just using this yield spread, however, this chart shows that EURUSD has an inverse correlation with the yield spread, so as the spread rises to multi-year highs, selling pressure is likely to build on the single currency. Since we have seen as low as 1.06 in the last year, this level is now a key support zone for EURUSD.

Figure 1:


Source: Bloomberg and City Index

Figure 2:


Source: Bloomberg and City Index

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