Euro/US Dollar Monthly Forecast For December 2008

Last month, I showed mostly monthly charts and multi-year forecasts. The first leg of USD strength (except for Yen) within a multi-year bull is probably complete or close to complete so this month I am focusing on shorter term structure. The EURUSD is at a crossroads right now. The immensely bearish implications from the long term expanded flat remain but it is unclear whether or not a larger recovery is underway from 1.2330. Only a rally above 1.3302 would suggest that a larger rally is underway towards Fibonacci resistance in the 1.36-1.41 zone. Until then, the EURUSD remains vulnerable to weakness in a 5th wave (unfolding as an ending diagonal at this point).

European and US interest rate forecasts have played a rather counterintuitive park in Euro/US Dollar price action, with markets often punishing major currencies with higher rate expectations. The ongoing financial crisis has clearly changed currency market dynamics, and it seems that few speculators are willing to chase high yields even in highly liquid currency markets. In fact, we recently saw that traders punished the Euro when the European Central Bank showed surprisingly little willingness to commit to aggressive interest rate cuts. ECB President Jean Claude Trichet has more recently softened his rhetoric on monetary policy outlook, and markets have accordingly priced in 123 basis points of ECB rate cuts in the coming 12 months.

How ECB rate forecasts will affect the Euro/US Dollar remains unclear. The US Dollar is likely to continue to move off of global economic risk sentiment, and further deterioration in financial market conditions would favor US Dollar strength. That being said, we may continue to see the Euro/US Dollar move inversely to rate expectations. If higher central bank interest rate expectations translate into financial market deterioration, the US dollar could continue to gain.

EURUSD Valuation Forecast: Bearish

Although the Euro has fallen nearly 20% since peaking in mid-July, the single currency remains substantially overvalued against the US dollar. That said, the Euro was the third-best performing currency against the greenback through October, adding almost 3%. On balance, valuation and the interest rate outlook suggest continued long term weakness in EURUSD but traders may see the pair underperform vis-à-vis the other majors.

What is Purchasing Power Parity?

One of the oldest and most basic fundamental approaches to determining the "fair" exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. For example, if a pencil costs €1 in Europe and $1.20 in the US, the "fair" EURUSD exchange rate should be 1.20. For our purposes, we will use the PPP values provided annually by the Organization for Economic Cooperation and Development (OECD). We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar. Currencies overvalued against the Dollar are denoted in RED, while those that are undervalued are denoted in GREEN.

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