Euro Correction or Reversal?

The key question today is whether the setback in the euro, after a marginal new high was recorded in early Asia above $1.3800, or if it is the start of a more sustained correction. Since September 10, the euro has advanced more than 9%.

In the three weeks since then, the euro has fallen one day in each week. The Commitment of Traders data released late Friday showed a large jump in net speculative longs. Recall that since from December last year through most of September, the net speculative position at the IMM has been short euros. At the end of September, the net position had swung long and last week, it jumped from almost 5100 contracts to 35.3k, which is the highest since last October.

My analysis has placed an emphasis on interest rate differentials. This continues to work in the euro’s favor. Last week, euro zone banks chose not to roll over roughly 80 bln euro financing despite the ECB’s readiness to provide an unlimited amount of 3-month money. Three-month Eonia stands at 71 bp today compared with 55 bp last week. Six month Eonia stands near 74 bp from 59 a week ago. The short-end spread is at new wide for the year today. The Dec 10 Euroibor vs Dec Eurodollar spread now stands near 72 bp from. The June 11 spread is also at new widening for the year. The two-year US-German spread widened to almost 44 bp in Germany’s favor before the weekend, which is the high since last December and is near 42 bp today. In addition to these interest rate developments, we note that the hourly RSI (14 period) is at its lowest level since this leg of the euro rally began on September 10. I am inclined then to view this euro pullback as a new opportunity to buy the euro.

There are varied voices from the Federal Reserve in recent days and the media has been playing up these differences. However, too often it seems, that not enough attention is paid to who actually is a voting member of the FOMC and who is not. Several of those who seem to be reluctant about embarking on a new long-term asset purchase operation, like Dallas’ Fed’s Fisher and Philadelphia Fed’s Plosser are not voting members.

In this context, we would place emphasis on NY Fed’s Dudley’s speech before the weekend. As the vice chairman of the FOMC his view is likely to be reflecting the emerging consensus. The key part of his message was he favors additional measures “unless the economic outlook evolves in a way that makes me more confident that we will see better outcome for both employment and inflation.”

Dudley also seemed to speak for an emerging consensus was he suggested that inaction is unacceptable when the tools exist that could help alter expectations and economic outcomes. On the other hand, the Us debt market has already responded quite favorably to the Bernanke’s Jackson Hole speech and the FOMC statement last month and, making conservative assumptions, it would appear that as much as half of the impact 25 bp of 50 that many expect may have already been discounted.