HomeMarketingTechnical Outlook for EUR/USD: Euro Crunch May Breakout Imminent

Technical Outlook for EUR/USD: Euro Crunch May Breakout Imminent

The European Central Bank (ECB) will likely intervene in the Eurozone financial markets again on Feb. 8. The trade-weighted euro is under pressure from gains in the single currency (USD). This could create a stronger-than-normal demand for U.S. dollar liquidity if risk appetite picks up and yields remain low, with negative implications for the relative strength of the euro versus a number of currencies, including ruble, yen, and pound sterling. More so, a possible rate hike by the United States Federal Reserve. Has raised interest rate expectations in Europe which have exacerbated due to market volatility and economic uncertainties in China.

Euro Crunch May Breakout Imminent

The Euro-zone financial markets will likely see a renewed round of ECB rate cuts, in an effort to keep the EUR from rising. With financial markets judged to be over-extended by recent central bank interventions, there may not be as much capacity for further cuts.

Yields on Eurozone 10yr Bunds declined for the 8th consecutive trading day today as core inflation held steady and forward-looking indicators showed no signs of recovery in the Eurozone economy. The EUR/USD pair rose strongly near 1.0850 following a strong USD rally yesterday, although slightly retreating below the 1.0830 level today after USD strength abated somewhat (see Daily chart – 1). The U.S. dollar was stronger against the Japanese yen today as well, rising above the 102.00 level to touch a level not seen since mid-November.

EU domestic debt financing: A trendless ride

The Eurozone has seen a major shift in domestic government financing (from direct to indirect and from private to public debt) during the course of the crisis. The proportion of total gross domestic product financed by domestic debt rose from around 24% in 2000 to nearly 40% in 2008. During the same period, gross public debt increased from around 19% of GDP to almost 50% (see Figure 1). Such a sharp increase in gross public debt renders most countries more vulnerable than historically ever before due–at least initially–to a higher share of their net exports in national income.

A Trendless Ride

We find that both the direct and indirect proportion of total gross domestic product (GDP) financed by domestic debt trended in a very similar manner between early 2000 and mid-2008. There was a sharp rise in the direct proportion of GDP financed by domestic debt from 2000 to 2004, followed by a more modest increase thereafter, with the indirect proportion of GDP financing growing at a higher rate through 2007. Most notably, there were no changes in the direct or indirect proportions of GDP that could explain why these ratios have not continued to fall during recent years. In contrast, gross public debt decreased sharply in both countries; its proportion of GDP declined from around 17% to nearly 10% between early 2000 and late 2008.

ECB’s next move after long bond-buying program?

The European Central Bank (ECB) is said to have purchased €1 trillion worth of government bonds in the last three years. This is three times the amount it buys each year under its normal operations and will likely put downward pressure on yields across the eurozone. At the same time, there’s renewed speculation of a premature tightening in the coming months as European politicians are getting increasingly irate about the currency’s strength, with Germany, Italy and France pushing for higher interest rates to ease pressure from their domestic economies. So how does that affect financial markets? There are two main considerations, says Chris Weston of IG Markets.

Outlook EUR/USD:

The euro has been underpinned by weak economic data, with the European Commission now predicting that the Eurozone economy is contracting at a 0.3% rate this quarter. That contrasts with the ECB’s earlier expectations of a 0.7% growth rate, which was weaker than thought. “The rationale for further QE interest rate cuts from the ECB is to improve its perceived credibility in supporting economic growth,” says Weston, “and therefore create a lower risk premium for investments denominated in Eurozone government debt.”

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