In 2020, the dollar continued to weaken as the Federal Reserve adopted a more accommodative policy relative to other central banks, which pushed the euro back above 1.23 against the dollar at the beginning of the year, its highest level since the beginning of 2018.
However, while a significant portion of market participants believe that the bear market in the dollar has only just begun and expect the dollar to depreciate by another 30% to 50% over the next three to five years, Rothko Research believes that the ECB will not allow the euro to appreciate unchecked against the dollar, as this would not only affect the EU’s economic recovery, but would also severely hamper the Inflation recovery.
According to Rothko Research, political risks in the EU are likely to increase as uncertainty increases and economic activity remains subdued, which could put downward pressure on the euro in the coming months. As a result, the EURUSD exchange rate is unlikely to rise above the January 2018 high of 1.25, and is more likely to retrace to the 1.15 level in the short to medium term.
Economic uncertainty and political risks
Rothko Research says that while vaccination is progressing “rapidly” in most European countries, there are still many risks associated with the outbreak in 2021, such as vaccine effectiveness falling short of expectations or governments imposing stricter travel restrictions to prevent virus variants.
Rothko Research believes that this will result in a severe blow to countries that are very dependent on tourism.
Most of the peripheral countries in the eurozone are very dependent on tourism, which is the main driver of their economic activity. Imagine what would happen to countries such as Cyprus, Greece or Portugal, where tourism accounts for more than 20% of GDP, if the outbreak is not contained by 2021.
The eurozone is divided into core and peripheral zones by economic strength. The core zone includes Germany, France, Italy and Spain; the peripheral countries include Austria, Belgium, Finland, Ireland, Luxembourg, the Netherlands, Portugal, Greece, Cyprus and 15 other countries.
Short covering in the US dollar
Rothko Research notes that despite the recent sharp recovery in the dollar index, the total net short position in the dollar remained high in January.
According to the U.S. Commodity Futures Trading Commission (CFTC), the net short position in the dollar increased to $25.7 billion, still at a very high level, with most of the short positions concentrated in the euro.
As a result, Rothko Research believes that the continued downward consolidation of the EURUSD exchange rate could lead to short USD covering in the coming weeks, which would exacerbate the EUR downtrend.
Although some analysts believe that the CFTC data shows only a small fraction of the foreign exchange market (with a daily trading volume of $5 trillion), Rothko Research believes this is an important factor to consider.
Trading EUR/USD via ETFs
The Euro Trust ETF (FXE) is a U.S.-registered exchange-traded fund that tracks the price of the euro against the U.S. dollar.
Among the factors that influence FXE’s movement are annual changes in the balance sheets of European central banks, as well as differences in real GDP and real interest rates between the eurozone and the U.S., according to Rothko Research.
For the U.S., the outlook for growth in 2021 may not be very positive, but Rothko Research believes that U.S. real GDP growth will outpace that of the eurozone, so this will limit the rise in the FXE.
There are periods of explicit disconnect between the Eurozone and U.S. real GDP differential and FXE price action, but Rothko Research says FXE will continue to decline if the downward revision of Eurozone growth expectations takes place.
In addition, real interest rate differentials have long been considered a powerful factor in currency movements, and as such, Rothko Research believes that a significant decline in U.S. real interest rates relative to the Eurozone in 2020 puts considerable downward pressure on the U.S. dollar; however, in the short to medium term, there is limited room for a decline in U.S. real interest rates and therefore little room for an upside in FXE.
While some investors believe the dollar will weaken again in the coming weeks, Rothko Research believes the downward pressure on the euro may be even greater.
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