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EUR USD PMIs may show us the way in 2018

Posted on: 23 January 2018 , by: Darren Sinden , category: Market Review

We have seen a positive start to 2018 as far as the Euro is concerned. 

The single currency entered the New Year with a US$1.20 handle. At the same time, the trade-weighted US Dollar (USDX) has printed to as low as 91.48. As we noted in comments made before the holidays, the US Dollar does not look likely to benefit from any improvements to the US economy from recent tax reforms passed in Washington DC. Forecasting FX rates over the long term is no easy task, and we need to consider a variety of factors when we do this. As such, we set out both a fundamental and technical view on the prospects for EURUSD below. So what are the factors that could affect Eurodollar in 2018 and what should we pay attention to along the way?

Fundamental Factors

There are hundreds of fundamental data points which can feed into FX price formation.

 But for our purposes here, PMI data, drawn from the two economies underlying the respective currencies, is very instructive, as we can see in the chart below. In this instance, we compare the so-called Composite PMI data. A metric which tracks economic activity across both manufacturing and service industries, and combines those data into a single composite figure,
where readings above 50 indicate growth or expansion.

Composite PMI

We can see significant divergence between the PMI data from the Eurozone and that from the USA. The deviation in trajectories began in August last year and continued across the balance of 2017. In fact, by year-end, the differential between the two readings was fully five points; an absolute difference of almost 10%. 

The data from the US for December was the weakest since March 2017. Suggesting that growth in private sector businesses, and by extension the wider economy, was slowing down.
By contrast in Europe, December’s composite PMI number was the strongest seen in the single currency area, since February 2011. In fact, the manufacturing component registered an all-time high, which was itself up from a high point in November. 

If we look at a three-year chart, of the annual growth in US GDP (GDP is a measure of the total output of an economy), and overlay that with the Composite PMI data for the same period (see below), you will see that there is a certain amount of directional correlation between the two data points. GDP is a lagging indicator as it is calculated in arrears, i.e. after the event. While the PMI data are survey based and as such are more current. They can, therefore, be thought of as being a leading indicator. I note that the US PMI is trending lower once more and where that leads, GDP growth seems likely to follow.

USD GDP Annual Growth and US Composite PMI

By comparison, both Annual GDP growth and Composite PMI within the Eurozone have been heading higher of late. Stronger PMI data across in the Eurozone will be seen as being bullish for the Euro by the market. A market that is now anticipating further tightening on the part of the ECB and the possibility of an end to negative interest rates, in the single currency, before the summer of 2019. 

 

EU GDP Annual Growth and EU Composite PMI

Against this background then it would not be a stretch of the imagination to see EURUSD move back to $1.2500 over the course of the first half of 2018, and indeed the Euro is testing towards its three-year highs against the US currency, as I write this article.

Technical Outlook

The Euro is pushing back towards an area of resistance that acted as an upside barrier to progress in the Autumn of 2017, as it became clear that the ECB would not be raising interest rates. That area is found between $1.2080 and $1.2092, where the latter figure is the weekly high from September 8th. To break above that autumnal high, it's likely that we will need to see the Euro move into and remain in, overbought territory. As measured by indicators, such as RSI 14. That won't be easy, simply because the Euro-Dollar has by and large respected the 70% overbought boundary used with this indicator, over much of the last five years. 

It's also true to say that in my medium-term model, the Euro is exhibiting only weakly bullish tendencies, against the US Dollar. Effectively it could be said to be running out of steam. But of course, an FX pair is just that, it's a quote made up of the relative valuations of two instruments, and while the Euro may only be in a weak bull trend versus the Dollar, the reciprocal relationship is a lot stronger. In fact in my model, I find that the Dollar is in a mid-strength bear trend, and has been since late November. We can see just how weak the Dollar has been of late, if we plot a chart of Euros per US Dollar, as we have below.

 

Potential Downside for the Dollar in terms of Euro

We can also get a very clear idea of the downside potential for the Dollar, (which of course is upside potential for the Euro) if we expand that chart over a longer time frame; see below.

 

Euro Per 1 USD

We can gain further insight into what may lie ahead if we compare the relative performance of the Trade Weighted versions of the currencies, which make up the EURUSD pair. Indeed we plot Dollar Index against its European counterpart below. Once again this chart is suggestive to me of further Dollar weakness and corresponding Euro strength. 

 Further Dollar weakness and corresponding Euro strength

In summary then both the fundamental and technical outlook could be said to be favouring the Euro. The wild card in all of this however could be the change in personnel at the US Federal Reserve. Who may have different views over the timing of future US interest rate rises. If it becomes clear that the “new management” favours a steeper rate rise trajectory or are happy to move independently of inflation and or wage growth data. Then the Dollar could yet stage a recovery. But, for now that's not how most of the market sees things developing. 

 

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