Category Archives: Currency analysis

Even more sex?

Well, it doesn’t happen all the time, but the EURUSD has performed exactly as expected since our last post.  And not only this pair; if you were short the Euro, you are “in the money” against most currencies. As I said then, it doesn´t get any better than this. The trade makes fundamental sense, and we have the POMO desk of the ECB covering our back. Sex has been good lately.

No overconfidence though. Nothing is really 100% foolproof, particularly in these turbulent times. Only two days ago, Saxo bank research came out with a long the EURUSD recommendation, with a target at no less than 1,40. Wow! I have great respect for them, and the rationale for the trade certainly makes sense. They think US interest hike fears are overblown. Most likely they are; but in my view, not to forget is the other side of the trade. The European growth scare is consolidating daily, and we are on target for the end of the year stagnation I suggested in “reading this and long time short the EURUSD”. Last figures show zero GDP growth for Europe in the second quarter (and likely coming down further in the third and fourth). Doesn’t look like the recovery everybody was expecting. I very much doubt the euro can withstand the dismantling of the growth prognosis now embedded in financial pricing in most of continental Europe. Some weakness looks unavoidable, even if we end up with a new “whatever it takes”, or similar wording, by super Mario. I think I will stick to the same sex partner (euro shorts) for the time being. A weak euro should help with some nice and reasonably safe sex over the next weeks.

Apart from our trade, Dollar longs and Euro shorts are the main theme in currency crosses. I am less certain of the longs. After all, the Fed is still a glamorous acronym for a bunch of money printers that have promised to abandon their addiction beginning tomorrow … or the day after. We have to remain a touch skeptical. Add the fact they don´t like the dollar to appreciate, because they are aware of the tightening of financial conditions implied by currency appreciation. Tightening is still anathema at the Fed. They fire you if they find out you ever dreamt of it.

Last in the main currency arena, the yen is a gambling choice. The country is bankrupt and sports sustained commercial deficits as a new part of the economic landscape. But it is also a large creditor, and still considered a safe haven by a large mass of ill-informed investors. Beware of behavioural economics. Millions of idiots can alter the investment outlook for “longer than you can stay solvent” (oh yes, I have something in common with J.M. Keynes).

It does makes sense to short the yen (long USDJPY) only if combined with a S&P500 futures contract short. “Risk on”-“risk off” wise, it balances out the trade, making it theoretically neutral to both scenarios. It is indeed difficult to imagine JPY appreciation combined with S&P500 further increases to the 2000 to 2250 area. Be careful with sizing both sides of the trade adequately: in most trades the devil is in those details. Timing the entry levels is tricky as well.

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Reading this, and long time short the EURUSD?

Congratulations. You are a survivor. Could be out of mere luck, or it’s just that you are very resilient. If you are the lucky type, you were either, rich, and able to withstand the loss, or you were fired, but they payed up to your golden parachute. If you can be included in the resilient cathegory, you are probably hard minded, and you dimensioned the trade reasonably, or used some stops on the way here.

Any case, regardless of the happy fact you left no widow or orphans, you’re still beaten up. EURUSD in the 1.36 area, with a recent top above 1.40, is something few bargained for just two years ago. Remember the lows at this time of the year in 2012? What a bounce for the value of the euro!

Backtrading is easy. In retrospect the euro did what should have been expected in this environment. It`s just that some of us didn’t see it coming. Valuations have never been a timing tool, but in the common knowledge game, where central banks intervene “all the time” and always win, valuations, and fundamentals, have become ultra long term factors. In the meantime, its “flow of funds” and “behavioural economics” that leads the way. If allowed to play by the nearest POMO desk on duty.

First of all, the euro tracked the “follow the money rule” outlined by (the antiaustrian/Mises skeptical) Milton Friedman. USD were being printed daily (well, more precisely on POMO days), and EUR were destroyed every month (LTRO repayments). That’s simple and straightforward supply and demand. And simple things always work first, and best. Knowing the LTRO would be repayed was not evident, but Bernanke’s printing couldn’t go unnoticed.

Second, trade balances still work. They are not as important as they were, not after we have all that global liquidity sloshing around. But, all things equal, 2% of the euro zone GDP has to be repatriated into euros yearly. That helps. Not the fundamentals –who cares about them any more-, but the flows matter.

Third, and foremost, the euro followed the route to be expected under the “common knowledge game”. The minute Dragui went all in to save the euro, hot money followed. And the euro profited inmensely from the common knowledge: “risk on is good because the central banks will not tolerate any negative outcome in the markets. Pick up yield (and risk).” This was particularly relevant for the euro because in the hunt for yield generated by the risk on trade, some sovereigns offered outstanding returns. The best public junk debt in the world, with the notable exception of Japan, is issued by euro sovereigns, in euros.

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Junk yen

One of the great mysteries of financial markets is the intrinsic value of the yen. Of course this mystery is applicable now, after the outbreak of QE has become “epidemic”, to the value of virtually all of the relevant fiat currencies. For similar reasons, the value of the US dollar is increasingly becoming suspect. The euro is hardly a currency, and up to now it has been a costly experiment for all involved, except the core.

We will comment on the EURUSD in future posts. But let me say for now, that political commitment (and the political capital already invested) can delay the result for the euro, but sound economics always generates the road map. A currency is really a claim on an economy, “vía” the balance sheet of a central bank. As a medium of value and exchange it cannot be delinked from the underlying economy. There cannot be one claim on multiple economies, unless the currency is used in a way that some of them subordinate to others. Can subordination to German policy be sustained in the long run? Without major adjustments, the Euro is not a viable currency. For Europe it´s either full integration, or disintegration, or splitting the currency in at least two.

Back to Fiat currencies and the Yen. The end of Bretton Woods, was “the end” of solid currencies, and the beginning of a truly fiat currency regime. The minute that central banks were independent, and could dimension their balance sheet at will, the value of the currency in their books became, to say the least, unclear. With the gold standard gone, the value of the currency became correlated only with the quantity and quality of the assets in the books of the central bank, and more indirectly, but finally, with the value of the underlying economy. Continue reading