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The bond markets are having a bit of a hissy fit, and as noted last week, this seems to be primarily driven by a position adjustment as speculation rises about the ECB's normalisation path. We also noted last week that the moves in the bond market had affected the FX markets, with the Euro perhaps slightly ahead of events. We thought we would take a closer look at the Euro this week, with our main conclusion being that the Euro is at a very interesting juncture.
First, let's have a look at the EUR versus the US Dollar. Chart 1 below goes back to 2014. After the significant decline between May 2014 and March 2015, the Euro has basically been range bound mostly between 1.05 and 1.15. We have highlighted two types of resistance. A horizontal line that sits around 1.1465 and we note that there has not been a weekly close above this level for about 2 1/2 years. We have also shown a modestly bearish trading channel connecting the spike highs of August 2015 and May 2016, and the upper boundary of this channel sits at 1.1450 (falling by 3 pips a week). So we have a strong resistance area at and just below 1.15 compared to last week's close of 1.14.
Chart 1 - EUR/USD Exchange Rate weekly chart
There is a bullish case to be made for the Euro, but this depends on the European Central Bank. If the ECB turns more hawkish than the markets expect, then we have to believe that the Euro will break above the 1.15 resistance area. If this were to occur, then there would seem to be little - technically speaking - to hold the Euro back from a sustained advance. We'll get to this bullish case shortly.
As you can imagine, the advance from 1.05 to 1.14 has caught the attention of many. Speculative traders (hedge funds), as measured by IMM data, are now holding the second largest net long Euro position since the financial crisis, as can be seen in chart 2 below. History shows that when position becomes too extreme, a reversal is usually close at hand.
Chart 2 - EUR/USD Exchange rate with IMM Euro positioning
It's not only the hedge funds that have fallen in love with the Euro in recent months. Chart 3 shows the EUR/USD FX rate alongside a bullish sentiment indicator of small traders. The 10 day average of bullish sentiment is currently 83% bullish, which is fast approaching levels that usually indicate exhaustion and potential reversal in the Euro itself.
We have taken this chart back to 2009 to illustrate one time when an elevated bullish sentiment was not a constraint on further Euro gains. As can be seen, by early June 2009, bullish sentiment reached the 80s and yet the Euro continued to rally from the low 1.40s at this time to a high of above 1.50 in October 2009. Furthermore, if we look at the same 2009 period in chart 2, we can speculators were also net long the Euro in early June.
As we should all know, there are no failsafe investment and trading methods in financial markets. No one method is 100% perfect. That said, when hedge funds are aggressively long the Euro and small traders are very optimistic, this should usually be seen as a contrarian opportunity which would have served well since 2010.
Chart 3 - EUR/USD Exchange Rate with bullish sentiment (10 day average)
Could we see a repeat of 2009 whereby the Euro can rally further despite extremely bullish positioning on the part of hedge funds and small traders? We think this depends upon the words and actions of the Federal reserve and the European Central Bank. Back in 2009, although both central banks had slashed their main interest rate to the zero lower boundary and the Fed was quite aggressively expanding its balance sheet. Let's also not forget that at that time, it was very much seen that the Global Financial Crisis (GFC) had originated in the US, and that the troubles for Europe were actually still ahead of them.
We should also remember that the ECB was still somewhat Bundesbank like with Jean-Claude Trichet in charge. As can be seen in chart 4, Trichet not only raised interest rates in the Summer of 2008 (literally weeks before the collapse of Lehman Brothers) because inflation was above 2% and even despite equities being in a bear market. Furthermore, Trichet also raised rates twice in 2011 to head off inflation even as the sovereign debt crisis was brewing. Our point here is that although IMM positioning and small traders bullish sentiment gave false signals in mid 2009, the ECB was very different at that time compared to the ultra-dovish Draghi today, and the Fed was hosing the system with liquidity whereas the ECB was not.
Chart 4 - Fed and ECB interest rates and balance sheets
Although we think that the recent rise in the Euro can be explained by the increasing optimism towards the Eurozone post the election of Macron in France, and noting the continued tailwind from an egregious German current account surplus, we simply do not think that Draghi is Bundesbank like. You can see this in the chart above. Draghi became President of the ECB in November 2011, since which time ECB policy has been significantly more aggressive than the Fed.
In our minds, to see the Euro break above the 1.15 resistance area, we either need to see a continued aggressive allocation by large investors away from the US (because of Trump's policies?), or we need the ECB to clearly articulate an end to both QE and negative interest rates within a reasonably short period of time. We believe this to be a low probability outcome as we continue to believe that Draghi will remove his highly accommodative policies at a very slow rate, not wanting to hurt the economic recovery that he will feel he has worked so hard to achieve.
At the same time, the Fed continues to stick with its narrative of gradual tightening which at the moment seems to mean one more rate rise this year, starting the process of balance sheet reduction perhaps as soon as September and three rate rises next year. The market, as it has done for years (and rightly so) is under-pricing the Fed, and is only pricing in a 50% probability of another rate rise this year, and only one rate rise for 2018. At some point, either the Fed caves in or the market has to price in a more hawkish policy.
So, although the bond market is rightly having a hissy fit about whether the ECB is moving towards the exit too quickly, we think that Draghi will try and dampen down these concerns (he can still hide behind the too low core inflation rate). We still think that future relative policies between the Fed and the ECB will favour a stronger US Dollar, and with the market now long the Euro, there is definitely potential for a position squeeze if this view is correct.
We would also note that the Euro is bumping up against resistance against the Pound Sterling as well. The chart below shows this cross rate on a weekly basis.
Chart 5 - EUR/GBP Exchange Rate weekly chart
So how do we play the Euro at this juncture? We do fundamentally have a bit of sympathy with the bullish scenario. A few weeks ago we showed the following chart between US and German 5 year bond yields and explained that we were positioned for German yields to rise more than US (we are long 5 year US bond futures and short 5 year German bond futures). Our base case scenario for the next few months is that the global economy continues to nudge on from here and that G10 central banks (excluding the Bank of Japan) will be removing stimulus and/or tightening policy in a measured way. In this scenario, we expect the current spread to remain around the 2% area in which case we earn a 2% return without any capital appreciation.
As readers will know, we also think that the Fed will continue tightening until something breaks. In this scenario, the Fed has a lot more room to ease than the ECB, and US yields would decline towards those seen in Europe, and we would earn our 2% carry and some (perhaps a good deal of) capital appreciation. In this more bearish scenario, which we have been pencilling in for later 2017, the Euro should gain against the US Dollar, at least for a period of time.
Chart 6 - US and German 5 year bonds
So although we do actually have a bit of sympathy with the bullish Euro thesis, we just don't think the time is right today. We think that markets are today under-pricing the Fed and over-pricing the ECB, and that those bullish of the Euro may be caught in a squeeze if market sentiment to either the Fed or the ECB has to change.
Presently, we have very little exposure to the Euro. The momentum has clearly been Euro positive since April and if we see signs of this reversing at clear resistance, we will look to put on some tactical short Euro exposure. However, we are trying to exercise patience in implementing this trade, as a break above 1.15 could happen, in which case we would go with the break given our sympathy to the larger bullish Euro potential.
As noted above, there are no failsafe investment methods to trading. All we can say about the Euro at the moment is that A) it is trading up to significant resistance, B) our work indicates that there is room for a tactical reversal from this resistance as the markets are potentially mis-reading the central banks and have become too optimistic on the Euro, C) if the ECB is seriously looking to remove policy accommodation, a break of 1.15 could open the way to a serious move to the upside and D) patience is a virtue but we expect to have more clarity relatively soon. We will of course update you with any actions we take in the funds we manage.