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The market is now focused on EURUSD falling down to 1.20. But where can it go from there and where do we look for clues? To answer this we need to look at the drivers of the euro in recent months. It is worth looking at the drivers of the euro since May when EURUSD broke out to the downside of the 1.35-1.30 range that had persisted since February.

The chief drivers since then have been: Spain and Italy's growing fiscal problems, election risks in Greece and the prospect of more ECB action to stem the crisis. At the same time as the euro started to decline we also saw the yen perform strongly and German short term bond yields fall below zero - suggesting risk aversion had gripped the markets.

What does this tell us? The euro is losing its yield advantage in the FX world and investors are moving into hard German assets as a hedge against a break-up of the currency bloc.

So the euro may not stage a meaningful recovery until 1, the ECB starts to regain its yield advantage versus the US dollar or 2, the threat of a break-up of the Eurozone is irradiated. However, these two factors are linked - the ECB needs to keep monetary policy extremely lose while politicians try and save the currency bloc.

This is one reason why we think the euro may not stage an extended decline below 1.20 in the medium term because the ECB's decision to cut interest rates to fresh record lows and cut the deposit rate (the rate banks earn by parking cash at the ECB) to 0% may help to ease credit strains in the region. Although yield is a major driver of FX, as credit risk deteriorates (potentially through ECB action) the currency may start to stabilise.

Although we think the road ahead for the single currency is going to be bumpy, in the long-term (6-9 months) we may see EURUSD trade between 1.15 - 1.35. It's notoriously difficult to accurately pick the lows and highs of the market, so a long term range-trading strategy may be more effective, whereby you leave a buy order at 1.15 and a sell order at 1.35 with a 200bp stop on either side. The stop may seem wide, but it is a long-term trading strategy so hence the risk parameters are a little wider than normal.

EURUSD: life over the next 6-9 months

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Source: Forex.com

 

Euro drivers to watch out for:

 

1, FX reserves in China

 

This has been a major support for the euro in recent years as central bank reserve diversification is thought to have helped prop up the euro. If reserves start to decline this is euro negative.

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Source: Forex.com

 

2, Yield differential

 

The euro swap rate that is based on Eonia (a European interest rate benchmark, is at its lowest ever euro-era level. How much further can this fall? It is already close to zero. We believe we would need to see all out panic if the yield falls any further, thus ECB cuts may already be priced in to the single currency.

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Source: Forex.com

 

3, German 2-year bond yield

 

As long as this remains negative it suggests heightened levels of stress in the currency bloc that could thwart rallies, hence in the long-term we see a cap at 1.35.

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Source: Forex.com

 

Of course, the euro is only one half of the EURUSD equation. We think the dollar is unlikely to stage a meaningful recovery and get back to the highs seen in the 80's or late nineties anytime soon due to fiscal concerns of its own. But that is the subject of another research note.

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e: kbrooks@forex.com| w: www.forex.com/uk

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