The firm, whose calls so far in 2010 on the EURUSD have been a reactionary disaster and cost clients millions, once again contemplates its navel, after the EURUSD has been trending increasingly away from its latest mid-term 1.35 target (but directly toward its 3 month target of 1.22). That said, it appears the Goldman FX guys are about to drop their 6 and 12 month forecasts on the pair once again, now that the EURUSD has tumbled almost 700 pips from recent 1.33+ highs, at the peak of Europe's artificial and so very temporary, export-driven economic golden age. Goldman's Mark Tan explains why.
EUR/$ has been Trading Strong, Especially Given the Peripheral CDS Widening
We have been keeping close watch on the EUR/$ price action and have been using a simple EUR/$ benchmarking exercise to give us a sense where EUR/$ should be trading given basic fundamentals. As Robin Brooks described previously (see Global Markets Daily July 6, 2010), this involves a regression incorporating 5y CDS spreads, 2y EUR and US swap rates, oil prices and the VIX.
EUR/$ seems to be trading strong currently, considering the widening in peripheral CDS spreads over recent weeks. A simple average of 5y CDS in Greece, Italy, Portugal and Spain shows an increase of around 140bps over the past month, now above pre-stress tests levels and not that far off from recent peaks. Our aforementioned benchmarking exercise gives a current EUR/$ value of around 1.22, which coincidentally also happens to be our 3-month forecast (which we had set when we last revised in mid July).
Correlations between CDS spreads and EUR/$ are still at extremely high levels, and as a result this simple benchmarking exercise suggests that EUR/$ should be trading lower. So what is causing this apparent disconnect?
Eurozone vs US Relative Data Surprises Have Been Supportive of EUR/$
One explanation could be that the recent widening in the peripheral CDS spreads is very different in nature to the widening observed in May/June. the funding conditions for the likes of Italy Spain and France are actually pretty much better. The widening is mainly driven by broader growth concerns. And as we expect growth to be broadly robust in Eurozone with significant differentiation across members, it is also likely that the response across different assets also varies and is much less systemic than in May/June.
However, another explanation could be linked to the magnitude of relative Eurozone vs US data surprises that we have seen over recent months. We can gauge the extent of surprises simply by looking at our proprietary Surprise Indices constructed by our European and US economics teams.
The US surprise index has been in negative territory over June and July, indicating that economic data has been coming in generally lower than consensus expectations, unsurprising given the slew of weak US economic data recently. On the other hand, our Eurozone Surprise index has been posting large positive readings in recent months. In fact, the July reading of our Eurozone Surprise Index is at the highest level of positive surprises since construction of the index. Overall, this means that the relative data surprises (looking at the EU vs US Surprise Index differential) has been massively favouring the Eurozone in recent months. The latest readings of these indices cover up to the month of July but looking at the trends of recent cross-Atlantic data, the latest relative surprise ‘spread’ should continue to remain wide and largely still in favour of the EUR.
The EU vs US relative growth surprises are to a certain extent captured by the inclusion of the EUR vs US swap spread in our benchmarking model described above. But assuming correlations with CDS spreads remain in-line with past trends, then it is plausible that the magnitude of data surprises that have been favoring the Eurozone are supporting EUR/$ to a greater extent than what is captured by the rate differentials. In other words, the hugely supportive Eurozone vs US ‘Surprise Spread’ seems to be a key factor that has been supporting EUR/$ recently, despite the backdrop of CDS spread widening.
Key Spreads to Monitor: Eurozone vs US Data ‘Surprise Spread’ and Peripheral CDS
This could mean that once this ‘surprise spread’ starts narrowing, we could see EUR/$ trade lower, especially if CDS spreads widen or stay elevated. This could happen as expectations for US data continue to be revised lower while Eurozone activity also start to moderate, which is to be expected after the inventory cycle led acceleration over the past few quarters. Meanwhile, Eurozone political tension could rise over the next few weeks as Thomas Stolper highlighted in last Tuesday’s Global Markets Daily. This is mainly the potential for rising tensions as most of Europe return from summer holidays. The next milestone to watch is the upcoming September 7 general strikes planned in France.
Indeed, we have accounted for these risks in our near term EUR/$ forecasts (1.22). One ‘technical’ impediment to this development could be that we just do not get that many Eurozone data points in the next few weeks while we continue to see ‘top tier’ macro data in the US which could continue to show softness (this week’s ISM and payrolls for example). The bottomline is that how these 2 key spreads (Eurozone vs US data surprise spread and peripheral CDS spreads) play out will be critical for EUR/$ direction in the near term.
Over the medium term though, our macro views are firmly lined-up in favour of EUR/$ strength. This is mainly the structural weakness in the US economy that the Eurozone is arguably less impeded by, the potential for renewed QE by the Fed possibly towards year end and the unsupportive BBoP backdrop for the USD. Overall, we think the risk lies towards moderate EUR/$ downside in the near term followed by eventual strength over the medium term, embodied in our current EUR/$ forecast of 1.22, 1.35 and 1.38 in 3, 6 and 12 months respectively.