EUR/USD - A Case Study In Divergent Monetary Policy
Position: Short EUR/USD
Entry price: $1.1823 USD
Target price: $1.1736 USD
Stop loss: $1.186 USD
Expected Returns (10x Leverage Assumed): 13.6%
Reward / Risk: 4.3x
2017 has been a year of exceptionally high returns and low volatility for the US stock market, which has been underpinned by a strong domestic economy. Strong economic growth in the US is evident from a 3% real GDP annual growth rate in Q3 2017. The annual inflation rate of 1.93% in Q3 is still below the Fed’s inflation target of 2%, but the inflation rate in September was at its highest since April 2017. This is a result of hurricanes Irma and Harvey disrupting production at oil refineries in the gulf coast area resulting in a 13.1 percentage increase of the gasoline index, a major factor contributing to the 2.2 % CPI rise over the last 12 months. The economy in Europe is also on track to grow at its fastest pace in a decade this year, with real GDP growth at an annual rate of 2.5% in Q3. This was mainly driven by increased private consumption and falling unemployment, However, inflation rose at an annual rate of only 1.5% in the same period which is one of the reasons why the ECB decided to continue with quantitative easing and is expected to keep interest rates at 0% up till September 2018 at least.
Overall, the EUR/USD exchange rate for the year was generally on an upward trend.
Chart 1: EUR/USD Resistance level
Chart 2: EUR/USD Support level
This implies that factors favouring the EUR/USD, such as strong economic growth data and greater investor confidence in the Eurozone, outweighed the effects of the divergence in monetary policies of the 2 central banks. However, as the Fed continues to hike rates as inflation in the US nears the Fed’s 2% target, while the ECB decides to only taper their bond-buying program starting January 2018 to September 2018, the difference between the 2 interest rates is likely to increase gradually over the course of next year, causing greater capital outflow from the EU to the US as investors begin seeking higher returns in the US. Hence, the divergence of monetary policies will continue to be a major determinant of the outlook of the EUR/USD.
The appreciation of the dollar could be further driven by investors´ expectations of an altered fiscal policy in the US. During his campaign in 2016, President Trump promised to strengthen the US economy by lowering personal and corporate taxes, spending a large amount on infrastructure and slashing regulation. His election then provoked investors to believe that the economy will flourish, resulting not so much in currency trades, but in rises in the stock market, with the S&P 500 up 18.28% since a year ago. The US dollar rose with the stocks but was also deterred by the failure of President Trump to carry out his numerous promises. The disparity between the detailed outline of the tax reform plan released on the 9th of November by the Senate Finance Committee and that of the Republican’s the previous week, heightened uncertainty revolving around President Trump’s Christmas deadline for a signature-ready piece of tax legislation, causing the dollar to slip to a 6-day low against a basket of currencies. It can thus be inferred that the strength of the US dollar has become increasingly dependent on the President’s ability to realize his policy plans. In light of the challenges he is facing, the market has not fully priced in the probable success of passing the bill by the end of the year. Given the importance of tax reform to Trump's political agenda and the recent news of the House of Representatives passing major tax reform legislation along party lines, there is a good chance of that happening which would jolt the economy, boost interest rates, and consequently strengthen the dollar.
Despite positive data on the Eurozone economy boosting investor confidence in the strength of the Euro, this could be negated by the political risks surrounding the eurozone. The results of the elections in Germany this year, which saw the weakening of Chancellor Angela Merkel’s party’s own hold on power, caused the Euro to retreat to below 1.18 against the dollar. Although the decline of the euro was short lived, it opens up a lot of possibilities as to what could go down during the Italian elections in May 2018. Insurgent anti-Euro forces in Italy, coupled with the country's fragile economy and weak banking sector, mean these elections pose a far greater threat to the post-crisis calm in Eurozone financial markets than the German election. Thus, the outlook of the Euro remains neutral and investors should proceed with caution.
Considering these factors, a possible trading strategy would be to go short EUR/USD. A strong U.S. economy, divergent monetary policy and the potential for tax reform in the U.S. provide fundamental justification for a continuation in the dollar's recent appreciation against the Euro. Furthermore, because the risk-free rate in the U.S. is 1.25%, relative to 0% in the EU, this trade generates a positive carry of 0.625% over our 6-month time horizon, regardless of fluctuations in the USD/EUR exchange rate.
A possible entry point into the market would be at 1.1823 and a possible exit point would be at 1.1736. Looking at the 6-month chart of the EUR/USD, it can be observed that there was resistance at 1.1823 several times since the end of July and support at 1.1710 over the same period. Considering the numerous anomalous peaks over the 6-month period, a stop/loss should be set at 1.186 which will give a risk/reward figure of 2.1192.