$1.32 Euro Under Construction

We pointed out 2 weeks ago that the ongoing decline (weakening) of the once strong inverse correlation between equities and USD would lead to a scenario of prolonged US strength regardless of the evolving trend in equities. As the correlation weakened from a strong -0.94 in November to -0.26 in the 1st week of January, it enabled us to forecast further advances in the greenback irrespective of intraday or daily moves in equities. By taking the other side of the coin and using the daily relation between EURUSD and S&P500, the positive correlation has now fallen from +0.94 in November to a statistically insignificant +0.27 (9-month low).

And as the relationship between FX and equities fades away, the role of yield differentials is strongly back in play, especially for the high profile EURUSD rate. The chart below clearly shows the correlation between German & US 10 year yield spread and EURUSD at an 8-month high of +0.61. Such strong correlation implies that as US yields (now at 3.68%) further gain above their German counterparts (now at 3.22%), the USD dollar strengthens further against EUR, thereby dragging down EURUSD. As markets expect the ECB to maintain rates unchanged (no tightening) and more FOMC members to dissent against the stance of exceptionally low levels of fed funds rate for an extended period, the US yield foundation is expected to further work in favour of the USD against EUR. The $1.38 target issued in January remains intact with a 60% probability of seeing a $1.32 in March.

Deepening the analysis into the sovereign spread situation, it is worth noting a possible recurrence of a double-take, similar to that March 2009. The charts in the lower frame below represent the spreads of 10-year yields of selected Eurozone nations over that of Germany (considered the safest bond in the Eurozone). Greek 10 year yields soared to as high as 400 bps above those of Germany, while Portuguese and Spanish yields hit 129 bps and 0.98 bps respectively.