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.
Standard risk free yield differentials (in the European case we are talking about core yields) also worked in favor of the euro throughout the curve, at least until the US bond market rout in may 2013. In the hunt for yield produced by ZIRP in the rest of the economic areas, the ECB stayed marginally above ZIRP, and US ten year bonds were roughly 100 basis points below actual levels. Only since the end of last year the treasury-ten year bund differential has tilted clearly in favor of the USD.
And, last of all, lots of the European corporate issuers of the Eurostoxx, were issuing debt well above the midswap (Italian or Spanish issuers). Only German or French issuers were getting a low yield spread as related to the midswap. Europe has been an obvious place to go yield hunting.
Things change, and, over the last six months, the arguments for a EUR debasement against the rest of the currencies have been put in place.
Money supply and demand of each of the currencies in the pair, is now definitively changing course. The Fed wants out of the money printing business (excuse me, I meant QE business), regardless of the fact they get done before October, or in November (I doubt the difference in timing is relevant enough). The ECB has just joined the money printing business, even though they need the cooperation of the banks. I fear some will be reluctant to help. When push comes to shove, they will give priority to their balance sheet strategic targets. In Europe that still equals deleveraging for the majority of the banking sector, led by Deutsche Bank. You want to be careful about this issue, but on balance the amount of euros should increase, and the money base of the Fed is not going to grow much more.
Yield differentials are now in bearish territory, short and longer term, for the EURUSD. No market reaction yet, but in a NIRP environment yield pick up matters a lot.
Common Knowledge game still applies, but market participants are receiving new inputs from the missionary (the central banks): “if we continue to be in control we will not tolerate further euro appreciation”. Should they lose control, the common knowledge game is finished, and the euro is back to 1,20 at least. So, both ways, the euro depreciates. For different reasons, and in varying intensity, but it is downward biased.
Yield hunt in the periphery ought to be finished by now. There is no further spread compression to be made, and yields are not above the USD yields. European Corporates haved succeded in incorporating a substantial amount of hot money into their balance sheets, vía strong primary market activity last year, so terms offered to the market should slightly deteriorate.
But the strong conviction call behind my renewed EURUSD bearishness is on the economic recovery. I expect it to wane, and certainly think the last quarter of the year will be a negative growth surprise (measured against expectations), particularly in Europe. I have no reason, other than hope, to expect a durable, robust recovery.
At levels a touch below 1.22, I also think the EURCHF offers a good short entry point. Very little upside, and substantial downside potential. You just have to be patient. Some day, some time, the SNB will allow the swissie to slide gradually past the 1.20 floor. In the meantime I see a low risk entry. You can gear up on this one.
This post will be a shortie. More next week.