Some quick thoughts on EUR, after our brief off topic discussion in a comment thread last week.
EUR has decisively broken out relative to the choppy, low-vol price action in front end rates.
And it has broken away from the pack vs. other DM currencies — this is the rolling 6mo total return on some of the big boys.
Some of this is due to better data, specifically PMI, which is at the highest level since 2011. This can plausibly be seen as a leading indicator of stronger growth…
Leading to speculation about the end of QE and higher rates — but with core inflation is still stuck below 1%, it’s just that…speculation. However, output prices in the PMI have moved sustainably higher after years stuck below 50. This moves the prospect of tighter monetary policy from “never gonna happen” to “better listen to Draghi.”
Despite the run from 1.05 to 1.12, EUR still looks cheap on a REER basis, and well below those at the top of the table…USD and CNY. In REER terms, EUR is cheaper than in mid-2012.
The potential for appreciation is there — the Euro area current account surplus has been trending higher for years, and is now sufficiently huge.
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But as noted in an excellent article in the FT by Matthew Klein, the mirror image of the c/a surplus is capital flight. Part of the reason the ECB went to negative rates was to reduce appreciation pressure by incentivizing capital to go elsewhere — capital outflows further driven by the moribund economy and better growth and higher rates in the US held the currency back for years.
This is a battleship that could finally be turning. That possibility has lifted positioning by speculators from a multi-year period of EUR bearishness:
But there are some signs we might be getting a little over our skis in the short-term:
Piecing it all together:
- I have subdued view of US and Chinese growth and the Fed,
- A potential downdraft in Chinese export demand notwithstanding, European growth is at an earlier stage in the business cycle, and
- There is a potential for an enormous reversal of capital flows that were beared up on EUR for years, especially after the ECB went to negative rates
- All that said, EUR has gotten out ahead of rates — something’s gotta give.
A lot of things have to go right, and Italy still has to get its act together — but I think there is room for EUR to run in the medium term. I’d look to pick up some cheap gamma for a secular move while protecting against the short-term frothiness and build a cash position on a pullback below 1.10 if the technicals clean up and fundamentals remain intact. In rates, I’d pay EUR front end rather than USD given the lag in rate spread relative to the currency; selling Eonia greens (basically paying 1y, 2y fwd) has a nice entry point and hasn’t steepened too much relative to reds, which sets up a good entry point.
