I have had a tough summer with my market calls. Not a lot has gone my way and it was one of those times when I would have been better off flattening all my positions and heading to the lake. One of the few trades that has worked for me has been my long US dollar call. The past couple of months, the dollar has been on a tear, rallying from 79.50 on the DXY index to over 83.00.
But now I notice that the large speculators are pushing their luck with big net short positions in both the Euro and the Yen.
As you know, I hate being on the same side as the hedge funds. Whenever a trade gets crowded, I find it better to silently slip out the back door.
Although I am by no means bearish on the US dollar, I think it is time to ring the register on this trade. Yesterday I covered half of my short CAD position, and all of my short AUD and NZD positions. I also decided to buy a little bit of EUR against my short CAD position.
Most traders will probably think that buying EUR into the face of all this bad news is madness. It might well be a stupid trade, but I think that the market has gotten ahead of itself in its discounting of ECB easing. My suspicion is that Draghi & Co. are going to disappoint on Thursday. This is after all Europe. The politics in trying to bring together all these different countries to actually implement new policy is like herding cats. And without a massive new QE program, the Euro is likely to rally.
Remember, Europe is mired in a deflationary vicious circle. Credit is being destroyed. And when credit is destroyed, the supply of Euros decreases. At the same time, during the past year the US has been expanding their balance sheet and creating more US dollars. And this is why, at the margin, the Euro has been stronger than most market pundits have forecasted.
However, currency prices are not solely influenced by relative Central Bank balance sheet size. Another big factor is relative interest rates. The recent move lower in European interest rates has been the driving factor in this summer’s move lower in the EUR rate.
This graph is a little more complicated than most of my charts, but I think it is important to show how there are two factors at work to explain EUR movement. During 2013 many forecasters were confused by the Euro’s strength. Since the relative interest rate was stable, the Euro followed the inverse of the ECB’s balance sheet change. The balance sheet was shrinking, so therefore the Euro rallied – much to most traders’ surprise since the European economy was obviously deteriorating. However over the past couple of months, as Draghi pushed overnight rates to negative levels, all the while the market has started to price in US Fed rate hikes, the widening interest rate differential has helped drive the Euro lower.
But for the Euro to continue going down there is going to have to be further widening of this interest rate differential or an expansion of the ECB/Fed balance sheet ratio. I am not sure how much lower German two year yields can be pushed as they are already trading at negative 2 basis points. Buying two year paper above par with a zero percent coupon seems like a pretty stupid trade, but I guess things can always get more stupid. There is probably a better chance that the spread widens because the Fed gets more hawkish and US two year yields spike. However, I think the Fed is going to be careful not to go too fast. I still contend that they are going to be slow at raising, and that the curve is going to get steep as the market realizes the Fed is going to risk higher inflation in an attempt to keep the economic momentum rolling. As for the balance sheet ratio, I do admit that the Fed is in the midst of winding down its expansion and that they are not going to be resuming QE anytime soon. But I believe that the market is overly optimistic about the ECB’s expansion. I have watched too many times the inability of the ECB to act. It will take a real crisis for them to implement a serious QE program. Right now inflation is low, but borrowing costs are also low. Politicians can push any problems into the future by simply borrowing more today at record low rates. There is no pressing reason to implement radical balance sheet expansion. In the absence of a crisis, I am assuming very little will be done.
That is why I expect the Euro to rally over the next couple of weeks. The hedge funds are heavily short. German two year rates are below zero and US two years have already priced in some tightening. I expect this week’s ECB meeting will be a dud and that they will simply hold open the door instead of walking through it.
I am buying a little Euro, knowing full well that I am catching a falling knife and that the trade is awfully lonely.