Forex Trading

The Euro has rallied decisively against the US Dollar this week, initially encouraged by a rebound in risky assets and boosted by news that the US Federal Reserve will buy $300 billion in Treasuries to lower long-term borrowing costs, weighing on yields paid on dollar-denominated assets. While the upswing has been impressive, evidence continues to suggest that it is a correction in the context of a larger downtrend rather than a sustainable rebound in the single currency, whether or not it is driven by risk sentiment.

Euro / US Dollar Has Been Driven by Trends in Risk Sentiment

Recent months have seen EURUSD exhibit a very strong correlation with trends in risk appetite. Indeed, the pair’s correlation with the MSCI World Stock Index (a composite metric tracking global stock performance) reached as high as 95.2% in mid-January and now stands at a formidable 90.2%. As global demand weakened, expectations of dour earnings weighed on stock markets and pushed traders to pull capital from equities and other risky assets to seek safe haven in the greenback: the US continues to have the deepest, most developed capital markets and the most stable geopolitical profile, making dollar-based assets the venue of choice for risk-averse investors. Further, the Dollar was the “least bad” play in a global recession scenario because US policy makers were first to cut rates, introduce fiscal measures, and otherwise stimulate the economy, suggesting the US would lead in the eventual rebound.

This week’s dual upswing in both stocks and EURUSD raises an important question: is risk aversion off the table as a driver of US Dollar strength? Some early signs of returning confidence are certainly being noted: UBS AG, a major bank, revealed this week that American hedge funds have become net buyers of US stocks for the first time since October. In the month to March 13th, purchases of equities by UBS’ hedge fund clients averaged $140 million, snapping 22 consecutive weeks of net capital outflow.

Has Risk Appetite Returned to Stay?

There are substantial reasons to believe that the current rebound in risk appetite temporary, leaving the door open for a return to safety-driven demand for the US Dollar in the near term. While economic forecasts from central banks, financial institutions and international bodies like the World Bank do not necessarily agree on the minute details of their 2009 growth forecasts, the overall picture is decidedly grim. The International Monetary Fund has been particularly explicit, calling for the worst contraction in global output since World War II. This bodes ill for demand and will almost certainly be reflected in disappointing earnings reports, keeping downward pressure on stock exchanges across the world.

Evaluating technical positioning, we see that the MSCI World Stock Index has been confined in a downward sloping channel since mid-October. The current rally began with a bounce at the bottom of this formation, and while there is still room to go until the channel top is tested, its downward slope argues for a bearish bias on risky assets for the time being. Topside is resistance is further bolstered by the presence of a falling trend line established from the highs in May of last year. Together these will present a substantial hurdle for risky assets, suggesting further losses lie ahead.

Risk Aversion Aside, Euro is Still Likely to Fall Against the US Dollar

Taking risk aversion out of the picture, the case for EURUSD losses still looks compelling. The latest economic forecasts reveal expectations that US economic growth will outpace that of the Euro Zone by the second quarter of this year, with differentials remaining in favor of the States into 2010. This suggests that the US Federal Reserve will lead the European Central Bank in starting to raise interest rates to rein inflationary pressure from the massive liquidity injections seen in recent months.



Further, the US government is almost certain to issue billions in Treasury bonds to finance the tremendous amount of deficit spending that has been undertaken to combat the crisis. This likely flood of government debt will send Treasury prices lower add substantial upward pressure at the long end of the yield curve. The US fiscal effort dwarfs anything that has been undertaken in the Euro Zone thus far, suggesting yields on US government bonds will see a far greater boost from new debt issuance and thereby become more attractive to investors than their European counterparts. All told, this scenario amounts to strong demand for the greenback and dollar-denominated assets at the expense of their Euro-based equivalents, pushing EURUSD lower.

Conclusion

The speed and magnitude of the rally in EURUSD seen in recent days has rightfully sparked questions about the possibility of a sustained rebound. The hint of a reversal in risky assets has fueled the notion that the single currency has put in a credible bottom against the greenback considering the pair’s iron-clad correlation to stock markets in recent months. However, current evidence suggests that the Euro is set for further losses against the US Dollar whether or not risk aversion returns into the picture.

Written by Ilya Spivak, Currency Analyst
Article Source - Euro / US Dollar : Is the Down Trend Over?