EUR/USD testing year low

EUR/USD is testing the year’s low of 1.2358 this morning following on from Friday’s ugly session for the single currency. 

EUR/USD
Source: Bloomberg

Mario Draghi spoke in Frankfurt on Friday and gave a fairly stark view that full-blown government bond purchases are now clearly something they are exploring. The ECB president detailed that if the existing set of measures do not prove ‘effective enough’, or if ‘further risks to the inflation outlook materialise’ then the bank will do more.

ECB member Vitor Constancio said on Saturday that he felt Europe is not at risk of ‘full deflation’, but he went on to say buying sovereign bonds is a possible option, seemingly backing Mr Draghi’s view.

This Friday we get European ‘flash’ inflation read and the market expects a slight tick lower to 0.3% (from 0.4%). There are economists who even expect 0.2% which would really see expectations for QE ramp up. It’s worth bearing in mind that yields in the various European bond markets are all at or testing record lows, so imposing sovereign bond buying seems to be driven more at boosting inflation expectations and liquidity than fixing the monetary transmission.

The will ECB look at the five-year swaps market and despite Mario Draghi giving a fairly dovish speech on Friday, we saw the swaps market tick down two basis points to suggest inflation will average at 1.78% over the coming five years. Given the ECB has a target of 2%, it seems the likelihood of doing more is now the markets’ base case scenario.

This now makes short EUR/AUD an attractive trade as the EUR is firmly the best currency to use as a funding currency in the carry trade. As you can see from the attached chart, EUR/AUD is moving into key horizontal support and a closing break of the July low of 1.4210 would suggest a deeper move to 1.3800.

We can also see it looks likely we will witness a bearish cross over in both the stochastic and MACD oscillator and perhaps this will be the key sell signal for short-term traders.

EUR/USD is a clear sell on rallies in my opinion. Strategists who run models on short-term ‘fair value’ would all agree that EUR/USD should be 200 points or so higher. So looking at traditional inputs such as swap or bond spreads, this really throws weight that rallies should be sold. From a more momentum-focused standpoint a daily close below 1.2358 (the 7 November low) would also correspond with a bearish crossover on the MACD and stochastic as well, so this is worth looking at too.

Traders really need to think about a world where QE is being deployed as a central policy tool; while this issue faces political push-back from Germany, the bulk of the ECB is seemingly on board.

EUR/USD chart

EUR/USD chart
Source: IG Charts

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