Faros Trading - Buy the Euro on Dips

The EUR/USD Remains a Buy on Dips

Lately we have pointed to a number of issues regarding the EUR and the USD. Over the past few days, we have worked on a predictor of the EUR/USD price based off a number of inputs; namely the European/US 2-Year Basis Swap (a measure of US vs. European interbank credit quality); the interest rate differential between Europe and the US in the 2-Year swap rates; the level of the CRB Index (a broad basket of commodities); and lastly the price of Gold as a function of the USD Index. Our analysis supports our view that the EUR is undervalued relative to the USD, currently indicating an undervaluation of about 16 percent. Much of this undervaluation comes as a consequence of the dollar's “flight to safety” status, a status we have lately questioned. The latest move lower in the EUR/USD came as the flight to safety trade was added to on fears over imminent Euro collapse brought on by news out of Ireland and Portugal. See Chart 1.

Our reasons for why we like the EUR/USD are numerous. First, we see continued demand from Asian Central Banks to buy EUR in order to diversify out of their overly long USD foreign exchange reserves. Secondly, we are growing more concerned over state and local weakness in the municipal sector. Be it in California, New York or Illinois, the daily headlines concerning fiscal and pension deficits are increasingly alarming, especially given the only way out is through bail-outs or economic growth, and given the latest data on housing and employment we do not see the latter as the near-term outcome. Recent squabbling in the Congress over the inclusion of the Build America Bonds program in the latest tax deal is sweeping the only support for the municipal sector from under its feet. (more)