Forex Investment and Currency Trading

The price action on EUR/USD since the beginning of December seems like a familiar story: the rapid rise of an asset being followed by a sharp fall, even an overshoot to the downside. Indeed, some expect EUR/USD to recover to the 1.4200 region by the end of 1Q 2009 with the dollar’s diminished level of yield support preventing a sustainable USD rally in the near term. However, the recent collapse of EUR/USD appears to be more of a EUR phenomenon than a USD story, with broad pressure on the single currency coming from the EUR/GBP cross as profit-taking trims its recent overshoot.

EUR/USD Began To Track EUR/GBP in Dec’08

Sterling came under extreme pressure as the market finally came to price in the aggressive monetary easing that would be required from the Bank of England. Indeed, the BoE has cut its key policy rate from 5.00% to 2.00% in just two months and the market expects another 125bp of monetary easing by the end of next quarter. However, the latest EUR/GBP surge appears to have been an overshoot on a speculative run to parity that was not wholly sustainable. The cross hit a new record high on December 5th and then continued to rally more than ten big figures before year-end, but the key two-year Eurozone-UK swap spread remained largely unchanged during these weeks.

Looking ahead, EUR/GBP faces the potential for some additional declines as profit-taking continues. Furthermore, EUR/GBP faces the potential for a modest loss of yield support if the economic data in the Eurozone were to experience further deterioration this quarter with the market having “only” priced in a rate trough of 1.50% for the Eurozone versus a rate trough of 0.75% for the UK. In other words, the two year Eurozone-UK swap spread could possibly decline 25 to 50bp in favor of GBP.

However, the broad macroeconomic backdrop remains GBP negative. Given the UK’s relatively larger dependence on the financial sector and more deeply indebted consumer (than the Eurozone), the market is expected to start pricing in monetary tightening from the ECB before looking for rate hikes from the BoE, providing EUR/GBP with additional yield support in 2H 2009. Furthermore, the UK’s large current account deficit will likely apply additional downward pressure on GBP in 2009 as foreign capital becomes more difficult to attract. In this context, the cross should remain supported throughout 2009 before peaking near parity in 1Q 2010. Nonetheless, a near-term stabilization of EUR/GBP in the area around 0.9000 should provide some relief to the broad based EUR weakness pressuring EUR/USD, leading to a renewed rally for the latter over 1.4000 in the coming weeks.