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The Trader's Guide to Eurodollar

Typography

What is Eurodollar?

Quite simply, eurodollar (also known as EURUSD), is the exchange rate between the currencies of the world's two largest economies when measured by GDP - USA and the Eurozone.

The Eurozone consists of the economies of 19 EU member states who have adopted the euro as their currency. These 19 member states have ceded control over monetary policy and interest rates to the European Central Bank. And as far as the currency is concerned at least they trade as one entity.

The European single currency or euro came into existence on the 31st of December 1998 when the rates of conversion for the founding members' domestic currencies were fixed. The non-physical format of the euro was introduced to the world on January 1st, 1999 while physical banknotes and coins followed in January 2002.

EURUSD had previously described U.S. dollars that were lent outside of U.S. borders, principally in Europe. There was and still is an interest rate contract with that name.

Despite the fact that this contract was and remains actively traded with millions of lots in open interest. The name eurodollar would usurp the interest rate contract and become synonymous with the currency pair on a daytoday basis.

Today EURUSD is the most actively traded currency pair in the world. According to data released by the Bank for International Settlements or BIS, in its 2016 triennial survey, the pair made up 23% of daily foreign exchange turnover. This totalled an average of US$5.1 trillion per day during the survey period. In comparison, USDJPY accounted for 17% of that daily turnover and GBPUSD or Cable, as it's known, just 9.2%.

What are the characteristics of the currency pair?

During its 18 year life, EURUSD has traded as high as $1.6019 in April 2008 and as low as $0.8230 in April 2000. During the course of 2017 EURUSD had spent much of its time below $1.1100 but since early May this year, we have seen a resurgence in the single currency. We will look at the reasons for this rebound a little later on in this guide.

As a result of the recent rise in the value of the euro, shorter term volatility levels in the EURUSD pair are also rising. But how exactly does the pair typically trade over the course of a business day?

Analysts suggests that the pair is most active during the London session. The largest price moves or ranges occur around lunchtime i.e. from 12.00 GMT onward.

There are two probable reasons for this. Firstly, New York markets are becoming more active at this point in the trading day and secondly major ECB policy and interest rate decisions are usually announced at 12:45 pm London time * (or 11:45 am GMT) with a press conference following 45 minutes later.

*London times are subject to daylight saving during spring and summer months.

Interestingly, Thursdays aren't the most active day for the currency pair even though it's the day the ECB makes its interest and monetary policy announcements. Rather, it is Tuesdays that see the biggest price swings when the week's tick data is averaged out.

Tuesdays typically see ranges that are on average as much as 10% bigger than those seen during the Wednesday, Thursday or Friday sessions. Meanwhile, the period between 12 and 3 pm GMT is the most active three of hours of the EURUSD trading day when ranked by the size of price movements in the pair.

It follows the idea that traders may find the best trading opportunities over European lunch times with Tuesday lunchtimes typically offering the most potential.

To keep track of where you are in the trading day, you can use Pepperstone's Smart Trader Tools. The session map plots progress of the market across the globe, meaning you don't need to worry about working out time differences. You can also use the candle countdown function to keep track of how long you have left in the period of peak activity.

Volatility

Even though short term volatility in EURUSD is rising, over a multi-year time frame EURUSD volatility is still falling. As seen in the CBOE EUVIX chart above, an index is created specifically to record the volatility levels in the pair. To be more precise, the implied volatility derived from the price of options on EURUSD.

This longer term decline in levels of volatility can be attributed to a relatively static monetary and interest rate policy from the ECB. The ongoing effects of aggressive QE and liquidity provision within the Eurozone along with issues in the European periphery such as Greece and failing Italian and Spanish banks have not caused significant political or financial damage to the Eurozone in recent years.

Macro drivers for the EURUSD exchange rate

In the period that followed the Global Financial Crisis or GFC, the euro faced several existential issues. Firstly, economic growth slowed substantially across all of the Eurozone as the global recession took hold. Perhaps more worryingly is the economies of individual member states, particularly those in southern Europe, failed to recover from those recessionary forces - necessitating bailouts and rescue packages. Most notably, in the case of Greece, where an ongoing mission between the EU and the IMF continues in order to prevent the country from sliding into an economic black hole.

At the height of this crisis, questions were asked about the sustainability of the Euro project as a whole. After more than two years of sustained ECB QE and the introduction of negative interest rates, things seem to be improving for the block collectively and not just for Germany which has often been the case.

The U.S. economy rebounded from the recession more quickly than Europe and the recovery seen in the USA also followed a more consistent trajectory. We can see this clearly when we compare unemployment data between the two economies. In the U.S., unemployment has fallen to just +4.30%. However, whilst the jobless rate has gradually been falling in the Eurozone, it remains at a disappointing +9.3% which is more than twice the current U.S. rate.

There are also large regional divergences within the Eurozone data. For example, unemployment in Greece stands at 22% whilst in Spain, the figure is 17.8%. In Germany, that figure is as low as 3.9%.

There are however some signs of convergence emerging between the Eurozone member states. According to recent growth data from the Economist magazine, all of the Eurozone economies were growing over the last quarter.

The ECB will hope that this level of convergence increases as its moves further through its asset purchase program.

Germany has effectively dominated the Eurozone since the financial crisis. A weaker euro has been massively beneficial to its export led economy and as a result, it has built up a large current account and trade surplus. It's something that Donald Trump and his administration have likened to trade and currency manipulation. Whilst it's true that a weaker euro has undoubtedly benefited German trade, the dollar has had its own issues to confront.

The U.S. dollar has underperformed significantly since Donald Trump's election victory in November 2016. Investors lost faith in the idea of the reflation trade and the possibility that fiscal stimulus (tax cuts and government spending) would take over from monetary stimulus.

Part of that transition was to be the normalisation of U.S. interest rates by the Federal Reserve even though we have seen 4 separate rate rises since December 2015. Markets remain uncertain as to whether the pace of growth / economic recovery in the U.S. will allow the Fed the latitude to move as quickly on rates as it would like.

Correlations with EURUSD

All currency pairs and crosses share some form of correlation due to the relationship they enjoy with the U.S. dollar and its role as global reserve currency and the comparative benchmark for all forex prices. However, these correlations can and do vary over time and can take positive or negative forms.

For the avoidance of doubt, under a positive correlation, a change in the value of A will result in the same directional change in the value of B. Whilst under a negative correlation, a change in the value of A will once again result in a change in the value of B. But this time that change will be in the opposite direction.

Currently, EURUSD shares a strong positive correlation with AUDUSD over time frames out to 1 month even though the strength of correlation weakens at 30 days and is actually negative over a six month time horizon.

Conversely, EURUSD is negatively correlated to both USDCAD and USDCHF. The latter has had a particularly strong reading over the course of 2017 to date with an average correlation of -0.87 (out of a maximum score of -1.0) over the first half of 2017.

EURUSD has historically been inversely or negatively correlated to the German DAX. A weaker euro has typically been positive for German equity markets as the country's exports become more reliant on foreign buyers as a result. On the other hand, a stronger euro tends to weaken the German index by making the prices of exports dearer to those same foreign currency buyers.

The chart above encapsulates this relationship over the period since late 2014. A weak eurodollar exchange rate has not been the sole factor behind the strong performance in German equities over this period but it has been a major contributing factor.

We can use the Smart Trader Tools Correlation Matrix to monitor changes in these types of correlations over various time frames and durations.

The Correlation Trader (see below) allows you to visualise, compare and trade correlations between assets in real time.

Monetary Policy / Divergence

Whilst the U.S. Federal Reserve withdrew from QE in October 2014, the ECB did not adopt unorthodox monetary policy until 6 months later in March 2015. It did so in order to stimulate growth in the Eurozone economy and to try to head off deflationary pricing pressures that had dogged the single currency economies since 2012.

As we can see from the chart above, the Eurozone inflation rates seem to be moving in a similar direction to the ECB's balance sheet which has doubled during the two years of QE to €4.246 trillion. This equates to an expansion of approximately €88 billion per month and counting.

Meanwhile, interest rates in the Eurozone remain negative with 3 month Euro LIBOR quoted at -0.37% as of Friday, June 30th. Under negative interest rates, the market is effectively paying you to borrow money. If that money is then invested outside of the Eurozone, it creates a downward pressure on the euro. Of course, US interest rates have been following an upward trajectory since December 2015 during that period we have seen 4 rises of +0.25% each.

Whilst the Federal Reserve continues to suggest that it will raise U.S. interest at least once more in 2017 and more regularly in 2018. The market is starting to lose faith in the Fed's ability to do so. What's more is that a series of disappointing U.S. economic data has been weighing on expectations about future levels of U.S. growth. The concern here is that if the U.S. economy should go into reverse, the Fed would have little room to manoeuvre on the downside.

Recent Performance

In the later part of June 2017, central bankers gathered in the Portuguese town of Sintra at the invite of the ECB who were holding a symposium. Among the many speeches and presentations was one by ECB chair Mario Draghi in which he inferred that the deflationary forces which had dogged the Eurozone for so long were now on the way out. This means the ECB would now be able to concentrate on inflationary forces in the Eurozone instead. It also implied a tapering of its current asset purchase plans and the possibility of future interest rate rises by the central Bank. Even though the ECB would later suggest that Mr Draghi's comments had been misinterpreted, the market chose to take him as this word.

EURUSD rallied from a low of $1.1182 to a high of $1.1349 in the space of one day which, as you have probably guessed, was a Tuesday namely the 27th of June. The euro would push on against the dollar to print as high as $1.1445 two days later before succumbing to profit taking and a small rebound in the Dollar.

To some extent, the genie is now out of the bottle as far as the possibility of an end to the Eurozone QE and the potential for interest rate rise thereafter. Having escaped it will be very difficult to get the apparition back into its vessel and out of traders' minds. To materially change the bullish sentiment currently surrounding the euro, we would likely need to see a consecutive series of better than anticipated U.S. data points or a very clear indication by the Federal Reserve that it wishes to retain its first mover advantage and will raise rates ahead of its Dec 2017 meeting - the next point at which the market believes it may act.

Summary

Markets are forward-looking and as such when they price, they are pricing for the future. Perhaps when the Fed indicated that it was to scale back its QE program, we had what was known as the taper tantrum.

Like all tantrums, the negative effects proved to be short lived. Markets reacted very negatively to the news and "risk assets" such as equities and emerging market currencies, which by large had benefited from QE, sold off sharply as a result.

However, there is a case to be made to say that the worst effects of the end of U.S. QE were mitigated by the massive expansion of the BOJ's QQE program in October 2014 just as the Fed shut shop. We might not enjoy that luxury if the ECB decides to taper asset purchases sooner than anticipated.

Market perceptions about monetary policy in the Eurozone and the U.S. will likely be the drivers in EURUSD over the balance of this year (2017) and into the next. Swings in sentiment may well form the directional cues for the rate in this period. As such, key data points particularly around inflation and levels of economic activity, will take on heightened significance on both sides of the Atlantic. That should create volatility and plenty of trading opportunities in the Forex markets' flagship instrument.

Pepperstone
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