John Taylor's Latest Take On Schrodinger's Currency: Sees EURUSD Going To Either 1.2650 Or 1.3625
The US and Eurozone Are Pursuing Different Policies
By John R Taylor/Jonathan Clark, FX Concepts
For member countries of the euro, the punishment for high deficits and attracting the attention of the financial markets is severe. Not only are countries like Greece and Ireland forced to adopt extremely austere budgets, but the bailout packages mean they are locked into paying very high interest rates for years ahead. Austerity in Europe means economic growth will be lower than would have otherwise been the case and euro interest rates should remain relatively low. The US is also faced with rising budget deficits, but the financial markets are not punishing the US for its fiscally lax policies and loose monetary policy. Now, President Obama has agreed to extend the Bush tax cuts for another two years for all taxpayers, but only by getting concessions to extend unemployment benefits and a 1-year 2% social security tax holiday. The result of this political compromise is a rise of US interest rates versus other countries and this is positive for the dollar. For its fiscal play, the US has gone from loose to tight.
The chart shows the tight correlation between EUR/USD and the interest rate differential between Germany and the US. When the interest rate differential widens the euro strengthens and when it narrows the euro declines. There can be lags at times as occurred in early August when the differential narrowed and the euro peaked four days later, but most of the times the lags are shorter. The market can ignore small movements as occurred twice in September (small blue arrows). However, if the US pursues expansionary policies and the Eurozone doesn’t, this should cause European interest rates to fall versus those in the US and the euro should also decline.
During the past two days the differential has narrowed between the US and Germany, but the euro has yet to show much weakness. The shorter cycles on EUR/USD appear quite clear to us and call for euro weakness into Thursday. There is a chance the euro has just formed a significant peak and if it closes below the strong support at 1.3030 it has begun a downtrend lasting into the end of the week of December 27 and will fall to 1.2650, signaling it is headed lower into April or May. If the next few days lack much weakness then the euro will turn higher and a close above 1.3375 signals it is headed higher into the middle of next week and will rally to the 1.3625 area. The movement in interest rates will be a major determinant of which course the currencies take.