DB FX Daily: EUR/USD Drivers -- What Has Changed, What Remains in Place

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FX Daily: EUR/USD Drivers -- What Has Changed, What Remains in Place

EUR/USD Drivers -- What Has Changed, What Remains in Place

The close below 1.35 in EUR/USD opens the possibility of the pullback in EUR/USD extending a bit further with the early December high and the 38.2% Fibonacci retracement around 1.3370 the next level in sight. It could take a move back above 1.3550 to regain some short-term stability. A few things have changed during this move lower in EUR/USD. Eurozone government and Euribor yields have come about 5 bps lower from the highs seeing spread trends slow and lessening the cyclical drive for higher levels of EUR/USD. The US yield curve has flattened as the mix of US data turned more positive for USD assets (mixed on economic activity, softer inflation numbers) even if the US economy still appears to be in the midst of a slowdown. The FX options market also seems to be signalling more concern over the downside risks in EUR/USD as 1M 25d risk reversals have moved sharply lower as shown in the chart at left below. What is worth noting here is that it has taken only a 1.5% decline from the highs in EUR/USD to take the 1M risk reversal to flat while declines of 2.5%in Sept-Oct and 3.5% in Dec-Jan were needed to shift short-term options market sentiment against the euro on previous occasions.

But several aspects of the environment which has driven the EUR/USD rally over the past six months remain in place. The tendency for EUR data to come in above the consensus and US data below expectations, which has generally been the trend since the middle of last year, has not clearly changed. As the chart at right below shows, we may have more mixed US data results recently but we have not moved into an environment of consistent positive surprises. Similarly Eurozone positive surprises remain in place. Thus calling an absolute peak in the spread trends which have favoured EUR/USD moving higher may be a bit premature. More structural factors may also still weigh on the USD including the rapid accumulation of FX reserves in large emerging markets which may present a supply of USD to the market. Finally short USD and long EUR positions appear to have moderated already as seen via our DB FX Positioning indicators in the most recent FX Strategy Weekly. Though we should note that short USD positions still remain firmly in place leaving some exposure to an episode of risk aversion.