FX Positioning and In-Depth Outlook

In the great ugly contest that is the foreign exchange market, a series of disappointingly poor US economic data had threatened to give the dubious honor to the dollar.  The euro had reached a 7-day high on July 19,  just below the key level we identified near $1.2330.   Sterling traded near its best level in a month, near $1.5740.   For its part, the Australian dollar had reached its best level since the end of April.

However, several developments at the end of last week again gave the euro the honor of being the ugliest.  And in turn, the euro dragged down the other major currencies, save the Japanese yen.  The yen is being bolstered even more than the dollar by the turmoil and is trading near its best levels against the greenback since early May.  

The latest developments in Europe are particularly troubling for investors.  First, the memorandum of understanding (MoU) between Spain and the EU and ECB to recapitalize Spanish banks was hardly 24-hours old when the second dimension of the country's debt problems resurfaced:  regional debt.  

The region of Valencia became the first region to formally declare its intention to seek Madrid's help to service its debt.  Five other regions quickly indicated that they would follow Valencia's lead.  It is feared that this will overwhelm the 18 bln euro fund the government earmarked to help the regions.

It plays on fears that Spain will have to seek a larger aid program from the Troika and not a narrow one simply for banks, which is the third dimension of Spain's debt problems.   Indeed, the MoU holds out the possibility the monies not used from the 100 bln euro package could be used to buy Spanish bonds.  

The 10-year yield finished the week at EMU-era highs near 7.27%.  The 5-year yield itself finished near 6.87%, perilously close to the 7% threshold.  The heightened level of market concern can be seen not at the long end, but at the short-end of the coupon curve.  

The 2-year yield rose 130 bp last week, twice the rise of the 10-year yield, to 5.75%.  Spain issues bills this week, but the almost 32 bln euro coupon payment and redemption on July 30 is also looming.  

II

Second, the ECB indicated was suspending as of the middle of this coming week the use of Greek government bonds and guaranteed instruments as collateral.  Greek banks will have to rely on the emergency liquidity assistance (ELA) of the central bank.  This lending is ultimately approved by the ECB, but the risks are borne by the Greek central bank itself. 

The ELA borrowing in June were published on July 17 and stood at 73.6 bln euros, an increase of 3.45 bln euros over the course of the month.  In mid-May, the ECB had approved an increase in Greece's ELA capacity to 100 bln euros.   

Many observers recognize that with no formal mechanism for ejection of members from the monetary union, one form it could take is for the ECB to deny a member's banks access to its liquidity provisions (though the collateral channel) and then limit the ELA.  This would in, fairly short order, force the country to create money in some form.

This is not that.  It is true that a former ECB board member had earlier in the week said weak countries should leave, but he spoke for himself and not the ECB.   Draghi himself affirmed that the ECB prefers that Greece remains in the monetary union.  

The ECB's decision is partly a technical move.  About four months ago, the ECB offered a "temporary suspension" of the minimum credit quality of the collateral it deemed acceptable.    The ECB is saying that the "temporary suspension" is coming to and end.  When the ECB's announcement was made, it also indicated that there was room to revisit the issue following the review of the Troika.   

This is also part of a larger issue for the ECB and that is the concern that through its collateral policies it has weakened its balance sheet.   Earlier this month, the ECB capped at current levels the use of government guaranteed bonds for collateral.  We argued that this would force governments to properly recapitalize their banks with new capital injections rather than guarantees and this would force the issue for many countries and tighten the growing link between solvency and sovereignty.  This can aid the ECB in its new role as bank supervisor.  There was also another motivation and that was the concern about the quality of the collateral and the risks of the ECB's balance sheet.  

Greece is understood by many observers to be the "canary in the coal mine" and so although the private investors account for only around a quarter of Greece's outstanding debt, it remains closely watched.  Investors are concerned that the Greek government is fragile and may not last.  It is also what former finance minister Papaconstantinou told the press,while the resignation of the head of the government's state asset sales, on grounds of lack of support from the government feed right into such concerns.  

Press reports indicate that Greece has missed roughly two thirds of the targets agreed upon in exchange for assistance.  Yet all the targets are not of the same gravitas.   The key be Greece's deficit measures themselves.  The government reported a 12.48 bln state deficit in H1 compared with a target of 14.88 bln.  The primary deficit stood at 3.32 bln euro.  The target was 5.27 bln euros.  Moreover, this was achieved with a decline in revenue (due to lower income tax receipts and less transaction tax receipts).  

This is not to say, of course, that Greece is not in serious trouble or that its current path is sustainable.  Rather the point is simply that a Greek exit is not imminent.  News that the European Investment Bank (EIB) will boost lending to Greek businesses is also supportive of this point.  That said, the EIB loans will increase Greece's official sector obligations.

III

The third important development that undermined the euro, and with it, the other major currencies and the risk appetite more generally, was the ECB's Executive Board Member Coeure warned that cutting the deposit rate below zero is an option.   

Coeure's statement was more restrained than the headlines.  He recognized that "it's unclear whether markets can function at negative rates.  Some can.  Some apparently can't.  So before making the next step, which would be moving the deposit facility to a negative yield, we'll reflect about it.    Clearly it was not ringing endorsement.  

Yet there is some precedent.  Denmark, for example, cut its key 2-week CD rate to minus 20 bp earlier this month.  Earlier in the crisis Sweden's Riksbank offered a negative deposit rate.  However, it seems like the risks outweigh the potential advantages for the ECB.  First, European banks have largely shifted their funds from the ECB's deposit facility to the current account and it does not appear to be a spur to new lending.  A negative deposit rate would accelerate the shift unless the ECB acted to prevent it in some form or fashion.  

More importantly, the zero deposit rate has hit euro money market funds, with several large ones closing or closing to new investors.  Euro money markets have been a source of funds for European banks (and some companies).  A negative deposit rate could only tighten the screws further.  

The ECB can cut the refi rate from 75 bp to 50 bp.  It could leave the deposit rate at zero.  The 50 bp spread is not unprecedented.   This seems by far the more likely scenario in the coming months than a negative deposit rate. 

On July 20, six European countries had negative 2-year interest rates.  In the euro zone itself, the FANG creditor countries (Finland, Austria, Netherlands and Germany) and two countries that move closely in the euro zone's orbit, Switzerland and Denmark have even deeper negative yields.  The negative yield in the FANG's is in the low single digits.   Denmark's 2-year yield was nearly -40 bp and the comparable yield in Switzerland is -54 bp.  

These negative yields are the mirror image of the high yields in the peripheral countries.  Yes, safe haven flows driving yields down, but what does this really mean?   We argue that perhaps the best way to understand the negative yields is as an option:  if the euro zone breaks up,  the currencies of the FANG countries and Denmark and Switzerland would likely appreciate and appreciate markedly (though there is some risk that such an environment, capital controls could be introduced).  This chance for currency appreciation will offset the negative interest rate.  If the crisis deepens, and it looks unavoidable at this juncture, yields can go into deeper negative territory.  

IV

These developments in Europe overshadow the mounting evidence that the US economy lost whatever mojo it may have had.  It is increasingly likely to produce some response from the Federal Reserve. Yet the deterioration of the situation in Europe is  more compelling.

The technical break down of the major foreign currencies just before the weekend means that IMM positioning data is less timely and revealing than at other times.   Still, we incorporate it within our review of the technical condition of the major foreign currencies.

The only major change in terms of speculative market positioning was a switch from a small net long Canadian dollar position to a small net short position.  It is the first net short Canadian dollar position since early February.

Euro: The net speculative short position increased slightly to 167.2k contracts from 165.7k.  Gross longs were trimmed by 4.6k (to 31.8k contracts) and the gross shorts were shaved 3k contracts (to 199.1k).

The euro is poised to fall further.  The immediate target is $1.2080-$1.2100.  The $1.20 level appears more psychological than real, and the low from this 2-years ago comes is near $1.1880.  Look for follow through selling after Friday's breakdown early in the weekend before  consolidation midweek ahead US durable goods orders and the first estimate of Q2 GDP.   The $1.22 area offers initial resistance, but the euro bears won't really be shaken unless $1.2330 is paid.  


Yen:  The net long position increased by 2.2k contracts to 11.1k.  It is the largest net long in almost a month.  Gross longs and shorts both added to position albeit in small size (3.8k and 1.6k contracts respectively) to 36.7k and 25.6k contracts.

The yen is poised to outperform in general.  The downside target for the dollar is JPY78.  A break of the last important low near JPY77.65 would likely seen official rhetoric increase.  But even more than against the dollar, technically the yen looks good on the crosses.  For those particularly aggressive with a strong risk appetite, long yen positions against the recently outperforming currencies, like the Australian and Canadian dollars and Mexican peso.   


Sterling:  The net short position hardly changed at about 7.5k contracts.  Both gross longs and gross shorts added around 1k contracts.  The gross longs stand at 33.9k contracts and the gross shorts stand at 41.3k.  Its gross short position is the second largest, behind the euro.

Sterling reversed lower on July 20 and closed below its 5-day moving average for the first time in six sessions.  This suggests the 2.2% rally off the mid-July lows is over.  The next target is $1.5580-$1.5600, but reasonable support is not seen until closer to $1.5525.   The first look at Q2 UK GDP will be reported at mid-week and a third consecutive quarterly contraction is expected.  It would not be surprising to see sterling extend its declines into the report and stabilize after it.  The $1.5660-80 area offers initial resistance, but the bears needs to see $1.5750 before they get nervous.


Swiss franc:   The net short position grew by nearly a third to 23.1k contracts.  The longs added less than 400 contracts, while the shorts grew 5.9k to 29.3 contracts.

The dollar finished July 20 at its best level against the Swiss franc since late 2010, a month or so after QE2 was announced.  There is no compelling technical evidence that the dollar is about to top.  The dollar looks to be headed to CHF1.0000-CHF1.0070.

Canadian dollar:  The net position swung to the short side but small beer at 1.2k contracts.  The longs were cut back by a little more than a thousand contracts to 23.6k, while the shorts rose 4.5k to 24.8.

Since early June the US dollar has fallen about 3.3% against the Canadian dollar.  That decline looks over or nearly so.  At least a corrective bounce seems to be at hand.  the CAD1.0150-70 area may prove a little sticky but the bounce should see the greenback move into the CAD1.0200-50 range.  This assumes the CAD1.0050-60 support area holds.

Australian dollar: The net long position was cut by almost a third to 13.9k contracts.  The longs were pared 3.7k to 51k contracts.  The shorts grew 1.4k contracts to 37k.

Since early June the Australian dollar has rallied almost 9% against the dollar.  The move too looks to have gotten a little long in the tooth and it did enter the $1.0450-70 resistance band.    The first test comes near retracements of the last leg up from July 12.  This can be found in the $1.0270-$1.0300 range.

Mexican peso:  The net long speculative position rose to 35k from 25.2k.  The longs rose by almost a quarter to 60.8k contracts, while the shorts increased by 2.4k contracts to 25.8k.

The peso has turned in a stellar performance since June 1, appreciating more than 10% against the dollar.  That advance also seems to have been completed or nearly so.  The new longs are in weak hands and vulnerable to a deeper setback than seen in the second half of last week.  The MXN13.43 and then MXN13.53 are the proximate targets, but given the positioning (which the IMM is just a proxy for as there are reports of large hedge fund and asset manager positions in the peso debt market), there is potential to surpass these initial targets.