Euro Breaks 1.40 After New Zealand Rate Cut

EURO BREAKS 1.40 HOW MUCH FURTHER CAN IT FALL?

The Euro broke 1.40 following the Reserve Bank of New Zealand interest rate decision as traders realized that the European Central Bank could cut interest rates over the next few months. Despite the hawkishness of ECB President Trichet, it should just be a matter of time before he gives in and cuts interest rates as well. For some investors like central banks who have deep pockets, EUR/USD at 1.39 may be a value play. But even if we see a relief rally in the EUR/USD, don’t expect it to last because the break of 1.40 could trigger a flush down to 1.39. On a purchasing power parity basis, the EUR/USD could fall as low as 1.15.

3 Factors Driving the EUR/USD Lower

1. Oil Prices Fall Despite OPEC Cut: There is a 70% Correlation between EUR/USD and Oil YTD
2. European Commission Slashes Eurozone Growth Estimates, Rate Cuts Anticipated
3. Risk Aversion: 1 Month ATM EUR/USD Volatility Hits Highest Level Since September 2001

Since the beginning of the year, there has been a 70 percent correlation between the price of oil and the EUR/USD. With crude prices edging lower despite a production cut by OPEC, the correlation with oil is a big reason why the Euro has broken 1.40. The European Commission also downgraded the Eurozone’s GDP forecast. The sharp drop in German exports suggests that the country could fall into a technical recession next quarter. Despite the problems, the growth story still favors the US over the Eurozone.

Volatility at 7 Yr High

One month at the money EUR/USD volatilities also hit the highest level in 7 years. Volatility peaked at 14.55 in the EUR/USD days after the 9/11 attack. We are faced with sharp volatilities once again with ATM 1 month vols at 12.63. High volatility tells us that the currency markets are still nervous but periods of high volatility usually precede periods of lower volatility. Back in 2001, after volatility peaked, the trading range in the EUR/USD contracted by 50% – that range lasted for 8 months.

Eurozone Needs a Weak Euro

The weakness of the Euro should be comforting for the European Central Bank because it is the answer to many of their problems. As an export dependent region, the slide in the Euro will help to support the economy, just like the weakness of the US dollar has contributed to corporate profitability. The Eurozone can also handle a weaker currency at this time because oil prices have fallen materially. Therefore don’t expect the ECB to stem the currency’s fall. We still believe that there will be further losses in the EUR/USD but not beyond 1.35.

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