Idea of the Day time to get serious on the euro

What: The euro is the third best performing currency vs. the USD today, as the single currency gets a boost from the surge in German bond yields to a 17-month high. Yields are a key driver of currencies, and the rise in German yields to above 0.5% is a significant level of resistance. Now that this has been broken, some banks including HSBC are expecting German 10-year yields to rise to 0.9% by year end.

We believe this will be a key driver of euro strength this year. Other factors include a pick-up in speculative long euro positions, which are close to their highest level since 2013. The economic and political backdrop is also supportive, with the debt crisis mostly confined to the past, the economy picking up speed and the unemployment rate dropping to its lowest level since 2009.

Overall, we think that this stage of the ECB’s policy cycle, where it has just shifted towards a less accommodative stance, is also euro supportive. This shift in the ECB’s stance is reflected in the yield spread between the Germany and the US, as you can see in chart 1 below. The spread is at its highest level since November, and it looks like it could continue to move higher, which is euro supportive.  

How: In figure 2 below you can see that EUR/GBP has been stuck in its tightest range for nearly 3-years. This is significant, with the ECB and BOE roughly at the same stage of their monetary policy cycles – both toying with the idea of taking a more hawkish path – this is limiting the movement in EUR/GBP. Thus, we would not suggest traders taking a position in this pair to capitalise on potential euro strength.

Instead, we believe that EUR/USD offers a better opportunity. From a fundamental perspective, we believe that the strength of German yields will continue to support EUR/USD, as you can see in chart 1. From a technical perspective, 1.1445 – last week’s high - looks like an easy challenge. Above here opens the way to a significant level of resistance at 1.15 – the top of the long term range. In the longer term a key resistance level to break is 1.1741 – the 38.2% retracement of the 2014 high to 2016 low, and then 1.20, which is a key psychological level. If German bond yields can reach 0.9% by year end then a 600 point move higher in EUR/USD looks like it could be a possibility.

Chart 1: 

Source: City Index and Bloomberg

Chart 2: 

Source: City Index