The European Central Bank’s (ECB's) final press conference of the year triggered euro selling on a combination of downward revisions in growth and inflation as well as Draghi’s indication that discussions over interest rates remained ongoing. The possibility for the refinancing rate to reach 0.25% without the Outright Market Transactions (OMT) having been deployed would be deemed excessive accommodation from the ECB in the face of a reticent Spain.
But what about the bigger picture?
The OMT program was aimed at enabling Spain to request a bailout, but it could end up eliminating such an event thanks to the stabilizing environment created by the September announcement. The positive impact of the OMT announcement on risk metrics has been impressive to say the least:
Peripheral sovereign bond yields have fallen 25%-30% from their August highs.
The November rebound in peripheral bond yields prompted by the post-Obama global market selloff proved relatively short-lived compared to the decline in global equities: -8% in equities, -15% in 10-year yields, -11% in oil and -6% in gold.
Even the euro's November selloff paled in comparison to equities, with a 3% decline from its October highs in contrast to a 6% fall in the S&P 500.
What Happened to our $1.35 Target?
The euro failed to reach $1.35 in November as we had predicted in September. We believe this was more a case of bad timing than merely bad direction. We have not abandoned this target because of the following:
Eurozone markets are no longer necessarily fair game thanks to Draghi’s backstop. Even if the OMT is contingent upon another country’s decision to request aid, there is always the LTRO option, which could be adjusted via duration according to the intensity required. At a time when even Troika recognizes the adverse global macro picture as a factor in Greece’s difficulty to meet its debt targets, there are always other tools for the ECB to use to contain contagion.
From a U.S. perspective, whether the fiscal cliff ends up breaking out or just being avoided, the materialization or the threat of a clear deterioration in U.S. growth (fiscal cliff may cause as much as 1% drop in GDP growth) will give no choice to the Fed but to resume (and possibly deepen) the policy of asset purchases. Such a U.S. dollar-negative program is likely to be magnified by the onset of the impact on Asia and Europe (China and Eurozone GDPs may lose by 25 bps and 50 bps from their respective GDPs), giving the ECB no choice but to step up another form of asset purchases, with or without a formal request for aid.
According to our proprietary long term monthly stochastics, we expect EUR/USD to rebound toward 1.32, followed by $1.33-34 nearing December. Interim downside target could extend to as low as $1.2630-50s (according to weekly oscillators) before mounting a December rebound.
The ensuing reverse Head & Shoulder formation appearing in EUR/USD is a classic (and rare) bullish formation, with clear delineation of: 1) required preceding selloff; 2) isolated low creating a left shoulder; 3) renewed sell off to create a bottom or a head; 4) subsequent peak creating a right shoulder; and 5) a straight neckline coinciding with trendline resistance. The theoretical target interpolated from the reverse Head & Shoulder suggests 1.38-40 is viable by the end of Q1 2013.