Recently there has been some concern over Euro/Dollar trade, while some analysts are pointing out that Euro might take further dip, especially with further easing from European Central Bank (ECB) as early as tomorrow, whereas others are pointing to Euro might be too over-shorted.

We, thought it would be good idea to evaluate the confusion, from fundamental point of view.

In our pursue for fundamental evaluation we look at the following -

• Big Mac index
• Purchasing power parity
• Long rates
• Short rates
• Ultra-short rates
• Policy divergence
• Current account

In our previous fundamental evaluation article we have already reviewed Euro and Big Mac and this one we focus on policy divergence.

Why policy divergence?

In today's financial world, central banks are a major player. Since financial crisis, major central banks around the world has pumped up liquidity worth $25 trillion. Now. After six year since the crisis, some central banks are considering to reverse course, while others are still pumping liquidity.

With balance sheet size in trillions of Dollars, these moves are enough to cause ripples in the market. May even cause tsunami, if the bank fails to manage their balance sheet reversal well.

Hence it is worth taking a look at Euro in the light of policy divergence.

Policy divergence between ECB and FED

As shown figure, Euro/USD since the crisis is showing high level of correlation with relative monetary policy divergence as measured in rate of changes in base money. While adjusted base money size is much higher than European Central Bank's (ECB), this year pace growth in base money have started to outpace that of FED's.

FED since last year has stopped purchasing assets, while European Central Bank (ECB) is about to build up on its current pace of purchase of € 60 billion per month, at tomorrow's meeting.

If ECB, do increase the pace of purchase, divergence will further intensify, building downside pressure on Euro against Dollar.