JPM Key drivers of EUR view

JPM Key drivers of EUR view

 Forecasts for EUR/USD (Q1 1.30, Q2 1.34), EUR/GBP
and EUR/JPY are unchanged from November 2011,
when we last revised targets (see Euro – the make or
break-up year, Global FX Strategy 2012, November 22,
2011). Those forecast profiles assumed the following
scenario: intensification of sovereign stress into early
2012, followed by stabilisation as the ECB/IMF provided
funding (ECB asset purchases, IMF credit lines) in
exchange for structural reform in Spain and Italy.
Massive liquidity is indeed stabilising the euro, though
relief is coming indirectly through the ECB’s 3-yr repo
rather than directly through asset purchases (these have
slowed to only €2bn per week) or IMF lending (major
reserve holders still balk at funding a rich and seeminglyuncoordinated
Europe).

 Still, the euro’s behaviour in recent weeks supports our
view that less sovereign stress is the key to euro stability
this year, far outweighing other euro negatives from a
bigger ECB balance sheet such as lower cash rates or
higher inflation expectations. Euro bears typically
emphasize the latter two influences, recalling the Fed and
USD’s experience with quantitative easing. But they
sometimes overlook three difference: the US runs a
current account deficit (Europe will probably post a
surplus in 2012); Fed QE lifted US inflation expectations
about150bp (European ones are up about 25bp); and
investors held record USD longs in 2009 (they are now
very short euros). Thus the currency-positive impacts
from falling credit risk have high odds of determining the
euro’s trend this year, which is why the forecast sees
EUR/USD in the 1.30s. The decoupling thesis made
popular late last year – stocks up, euro down due to a
larger ECB balance sheet – is less convincing once one
considers the various ways that balance sheet expansion
influences currencies.

J.P. Morgan forecasts EUR

Risks to the view
 Risks to the forecast are to the downside in Q1, since
the Greek debt swap will be difficult to execute
smoothly. Europe seems to have set an impossibly high
hurdle by asking for 100% participation and eschewing
additional funding for Greece. Either bondholders or the
EU will need to change their position in order to avoid a
disruptive credit event in Q1.

Short-term valuation model
 A short-term cyclical model relating EUR/USD to daily
levels of Euro – US rate spreads (1-mo rates 12-mos
forward), sovereign spreads (5-yr Spain, Italy, Portugal, Ireland
and Greece vs. Germany) and equity volatility (VIX)
suggests that 1.30 is fair value based on current
fundamentals (chart 2). The intuition is the following: the
ECB’s 3-yr LTRO has compressed EU – US spreads
over the past month (euro-negative) but it has also
lowered equity vol by four points and tightened
peripheral spreads on average (both euro-positives). The
combination of these variables justifies EUR/USD at
current levels.

Long-term fair value model for EUR
 Our long-term fair value model regressing the tradeweighted
euro on quarterly variables such as debt levels,
terms of trade and productivity differentials suggests that
the currency is about 5% too strong – it is roughly 5-6%
expensive to USD, but close to fair vs CHF. As a
contrarian indicator, however, long-term valuations
models have performed more poorly for EUR than for
other currencies given the estimation problems associated
with a currency only ten years old.

Technicals

 While the medium term bias remains bearish, a short
term corrective phase is underway. This follows the test
and effective hold of the key 1.2600/1.2588 support zone
amid a deep oversold framework. Note this area
represents the 76.4% retracement of the advance from the
2010 low, the August ’10 low, as well as the key channel
support from the August ’11 peak. Importantly, this area
will maintain the potential for further short term
recovery.

 Still, any further advance should find key resistance
initially in the 1.3077/1.3100 area, before the important
1.3200/1.3250 zone. This area includes the mid-
December breakdown and reaction high, as well as the
38.2% retracement from the October peak. Note these
levels should define whether a deeper retracement is
underway. Failures leave the door open to additional
medium term weakness with violations of the 1.26
support area seeking a closer test of the 1.20/1.1876 zone
(2010 low).