EURUSD: up, up, and away and then back down

UBS analysts maintain their call for EURUSD to top out over the next few months and the greenback to rebound later in the year. While US fundamentals are currently negative, the USD should eventually benefit from improved economic conditions and technical buying. UBS analysts capitalize on a cheaper USD in the short term, and then suggest being long.

US fundamentals are beginning to deteriorate, and markets are pricing in Fed rate cuts. UBS analysts were expecting this when they set the three-month forecast for EURUSD at 1.34. UBS think markets will need to anticipate one or two more cuts before they are fully prepared for the US slowdown. On the other side of the pond, a strong macroeconomic story in the euro zone is pushing the EUR up. The ECB has increased its 2007 GDP growth forecast and left open the possibility of multiple hikes.

There are solid foundations in place for EURUSD to rise to UBS’s forecast of 1.34 and maybe even a bit higher. They are also perfect for exploring ways to profit from EURUSD topping out soon. Markets will price in good European and bad US news in the short term. However growth is also likely to slow in Europe this year and in 2008. The Fed is poised to orchestrate a soft landing in the US, isolating the pain from the housing slowdown. Once US and European interest rates have converged, a focus on US growth should support the dollar.

There are also technical and portfolio reasons limiting EUR strength. Whenever EURUSD goes above roughly 1.35, EUR selling predominates and moves the pair back down. This is critical given the high volumes of EUR-long positions in international money markets, and provides ammunition for downward EUR moves.

UBS analysts therefore continue to expect the EURUSD to reach 1.34 in the next few months. Investors are well served by long positions in EURUSD in the current environment. However such positions should not be held into the second half of the year, as the USD is likely to once again strengthen to 1.25 in 12 months time.