There are three key factors contributing to a stronger EUR/USD:
- First, European sovereign tail risks are diminishing. The political situations in Spain and Italy are a near term concern, however, the euro’s existential crisis is over. According to Intrade, the probability of a country leaving the eurozone by the end of 2014 has dropped from a peak of near 75% to 20% today.
- Second, the ECB is not participating in the “currency war”. ECB President Draghi is not particularly worried about the current level of the euro, noting that the real effective exchange rate is near its long run average. Meanwhile, the ECB’s balance sheet is slowly contracting as banks repay their LTRO loans.
- Third, the euozone’s balance of payments is improving significantly. The trade surplus reached a new record high of €12 bn in December. This suggests that the current account surplus continues to grow. With long term capital inflows also turning up, the basic balance surplus is increasing.
Bottom Line: Maintain a long EUR/USD position.