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Heavy Euro Buying By Central Banks a Sign EUR/USD Has Probably Put in a Bottom

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Image © European Central Bank

- 1.14 lows could be trough in the market

- Pivot around August lows further reinforces bullish longer-term view

- Short-squeeze driving EUR/USD higher short-term; Italy concerns in the balance

Evidence of heavy Euro buying by central banks at the recent EUR/USD's 1.14 October 9 dip lows could be a significant signal the pair is reversing trend based on previous historical precedent.

Central banks tend to be savvy investors and the levels at which they decide to purchase the Euro tend to mark significant low points for the currency.

The heavy buying in the 1.14s strongly suggests they viewed the level as a bargain-point.

"Central Banks do have some history in being aggressive buyers of EUR at low-points in EUR/USD. Two of the previous three most aggressive quarters of EUR buying (Q2 2010; Q2 2012) closely coincided with major EUR/USD low-points (11th June 2010 1.1968; and 27th July 2012 1.2043)," says Derek Halpenny, European head of Global Markets research, at MUFG.

"More recent important lows in EUR/USD were also points of aggressive EUR buying by central banks," adds Halpenny, citing Q1 2015 and Q4-Q1 2016-17 as quarters which saw central bank purchasing close to three times more-than-the-average since the COFER data series began back in 1999.

From a technical and valuations standpoint, there is also evidence supporting the idea that EUR/USD has put in a significant low in August.

A three-month pivot swing pattern around August's hammer low, suggests the longer-term trend may have rotated higher.

The exchange rate confirmed the signal when it broke above the July 1.1791 highs in September.

Unfortunately, the pair failed to follow-through and fell back after that. However, the signal was not invalidated either and it EUR/USD could still break higher.

A move back above the 1.1791 July highs - or September 1.1815 highs for more security -  would reinvigorate the bullish signal and provide a fresh buying opportunity.

The Euro is also considered undervalued compared to the US Dollar, according to Effective Exchange Rate (EER) data from the Bank of International Settlements.

EER values a currency based on fundamental data. The closer the valuation is to 100 the nearer the exchange rate reflects the 'real' fundamental value. If it is higher it means the currency is overvalued; if lower then undervalued.

In the case of EUR/USD, the respective EERs are 95 and 115, which suggests the Euro is modestly undervalued and the Dollar very overvalued.

The pair is supposed to drift back to 'fair value' over time, so this suggests the US Dollar will drift down and the Euro up over time. This further supports the hypothesis the pair may be about to change trend and move higher.

Analysts at Reuters also see short-term signs the trend is turning as EUR/USD rises in a 'short-squeeze', which happens when a heavily bearish market is taken by surprise by a sudden rebound and bears start frantically closing their bets as they witness previously profitable positions become loses.

This creates a 'negative' feedback loop higher, which drives the exchange rate up even more rapidly. Reuters, nevertheless, expect EUR/USD gains to be capped by Italian risks "next week".

"Tight early range after closing +0.7%, as USD longs continue to exit. Italian budget issue may cap next week," says Andrew Spencer, an analyst at Reuters, who sees a close above 1.1578 as 'game-changingly' bullish.  

Analysts at Nordea have argued that the Euro will bounce eventually, as Italian budget concerns are destined to ease.

They argue it is inevitable that Italy's government will eventually bend to the will of the markets, reduce their budget deficit and keep borrowing costs affordable.

They further forecast the Dollar will peak in mid-November when the US reaches its debt ceiling again, forcing the Treasury to start using up its circa 300bn of reserves, the injection of which will flood the economy with Dollar liquidity, diluting the value of the US currency in the process.

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