A look into the history of EUR/USD and Fed tightening

The Euro traders are anxiously awaiting the ECB meeting due next week and the Fed rate decision due Dec 16. As of now, the markets believe the ECB would announce more easing next week and the Fed shall begin tightening at Dec 17. 

What the ECB would do (rate cut/QE) or whether the fed liftoff would happen or not or would it be a 25bps hike or less than 25bps hike can be kept aside for now, and we can have a look at how the EUR/USD pair behaved in the last few Fed tightening cycles.
Before that, few of the following things may be worth noting – 

• EUR is no longer a risk-on currency: It is not a safe haven as well, however, it surely is a funding currency and it is pretty much evident from the sharp spike in the EUR during the bouts of risk aversion seen in August. 

EUR/USD and DJIA Comparison

Since the 1990s, the EUR’s risk-currency status had started building up. Post the Dot com bubble, the direct correlation between the EUR/USD and DJIA strengthened and remained intact till the EUR crisis erupted in 2010. But the direct correlation came under fire in May 2014 when the ECB hinted at unprecedented policy stimulus.

From June 2014, the EUR and the DJIA have moved in the opposite direction, which clearly states the EUR is a funding currency now and not a risk currency any more.

• Fed is facing a new normal: The Fed hiked rates by 25 bps are regular intervals during the last three tightening cycles. Furthermore, liftoff back then did not follow QE taper, since there was no QE back then. This time, the Fed has had unprecedented 3 rounds of QE, followed by a Taper and now the bank is on the verge of raising rates for the first time in a decade. The response to the 2008 recession was unprecedented (3 QEs+record low rates i.e new normal) compared to previous recessions (easing cycles), hence the tightening is more likely to be at a new normal pace of less than 25bps hikes. 

EUR/USD response to past Fed tightening cycles

• 1994-1995: EUR/USD rallied from 1.1148 (Jan 94) to 1.3822(topped out in 1995)

• 1999-2000: The Dotcom bubble was in the making, and thus attracted capital flows. The bond yield differential was in favour of the USD. Asian crisis also reversed flows to the West, mainly to US. EUR/USD fell from 1.1750 (Jan 1999) to 0.8230 (bottomed out in 2000). Post 2000, the EUR became a classic risk-on currency and EUR/JPY a global barometer of risk sentiment. 

• 2004-2006: The tightening began from May 2004 and it was accompanied by a spike in the EUR/USD from 1.2593 to 1.3660 (in December 2004), which was then followed by a drop in the EUR/USD pair as signs of the crisis started emerging! (EUR was risk-on currency)

Now, the Fed is on the verge of another round of policy tightening. As said earlier, the new normal is likely to be a less than 25bps move. Nevertheless, the EUR could rise in line with its history once the liftoff begins. No wonder, ECB’s Draghi surprised a month back by hinting at more easing in December. 

Hope ECB meets market expectations or EUR bears could suffer heartbreak

• Is ECB action priced-in: Following Draghi’s Oct presser, the German 2-year yields hit record lows and the EUR/USD is down almost 1000 pips. And now the EUR/USD has stalled around 1.07 levels. The chart is showing indecisiveness. The RSI is forming higher lows, while the price is forming lower lows. Overall, it appears the ECB action – deposit rate cut and extension/expansion of QE could have been priced-in. 

• If the ECB falls short of the expectations, the history could repeat itself after the Fed liftoff in December. 

• What is worth noting is that EUR rallied (2 out of 3 times) in last fed tightening cycles even though it was a risk-on currency back then. 

• Now, the EUR is a funding currency and thus a spike could be sharp following Fed’s liftoff if the equity markets turn risk averse. 

On monthly chart

The sell-off could come to a halt around 1.0390 (long term trend line support). A monthly close below the same would mean a bearish break from the falling channel and could reinforce expectations of sub-parity levels.