•  2-year yield spread between German and US debt reaches multi-year high, suggests further EURUSD gains
  •  IFO/ EURUSD - single currency trades like the deutschmark

I often update the interest rate spread between Europe and the US, as I find this a good way to try and determine where forex rates are going.

There has been an interesting development in the spread between German and US rates that is worth pointing out. 2-year yield spreads have broken out above the 0.6870 - the November high, to 0.6780 currently , as you can see in the chart below. This is the widest the spread has been since November 2009.

This development in the spread suggests further gains in EURUSD, possibly back to the 1.4207 high reached on 4 November 2010. This level will be formidable resistance and it would take a mighty push from the bulls to get above this level, but there is still a way to go before we reach 1.4200.

As we have mentioned before, due to the continuing sovereign problems in the euro-area we don't think that EURUSD will move higher in a straight line, and it could be a bumpy journey over the coming months.

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Backdrop to a stronger EURUSD:

News that new California governor Jerry Brown has declared a fiscal emergency in the most populous US state yesterday due to a $25.4bn budget gap highlights the debt problems in the US. While the focus since 2010 has been on the fiscal issues in peripheral Europe, this could shift to the US.

Without an extension of tax rises that is scheduled to go to a public vote later this quarter, it will be very difficult for California to get its budget under control. Like peripheral Europe, the US faces a period of fiscal adjustment over the coming years, but unlike Europe it doesn't have a financially powerful Germany figure to bolster its finances.

Until the US gets its states on a sustainable fiscal path, we think the bias will be for a stronger EURUSD.

Is the euro trading like the deutschmark?

 

Based on the relationship between the IFO measure of German business confidence and EURUSD you would think so.

As you can see on the chart below, the two tend to move in the same direction (IFO business climate index is white line), although the IFO tends to overshoot on both the downside and the upside relative to EURUSD.

The strength of the German economy is well-known, and as long as German growth holds up and investors have faith that Eurozone officials will muddle through to find a solution to the sovereign debt crisis then this should benefit the single currency. Essentially a stronger Germany has more firepower to protect the peripheral nations during the current debt storm, so it is no surprise that the currency trades in line with Europe's largest economy. Recently Germany has also appeared more willing to protect the Eurozone and the euro during the sovereign crisis, which is boosting investor confidence and is further good news for the single currency.

 

EURUSD (orange line) and the IFO measure of German business confidence

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Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

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