Price Action Does not Mean the Euro has Bottomed

There has been no follow through selling of the euro after yesterday's bearish price action.  Yesterday, the euro first traded above Monday's highs, then broke down to trade below Monday's low, and record new three month lows.  It finished the North American session below Friday-Monday lows, completing what technician call an outside down day.  

The euro is trading within yesterday's ranges, but the lack of follow through selling does not mean that the move has been exhausted.  Leaving aside the very near-term, the fundamentals we would emphasize and technical considerations still point to a weaker euro.  As we have since the end of last year, we expect the euro to finish the year closer to $1.20.

Economic activity in the euro zone has contracted for 6 consecutive quarters through Q1 and appears to have contracted further in Q2.  While some survey data suggests a mild recovery has begun, it is preliminary and there continues to be significant headwinds.  Some of those head winds are internally generated, but some, like knock-on effect of rising US rates, are not 

When thinking about currencies in the context of policy, what is important is the trajectory of policy not just its current setting.  The verbal communication about tapering is part of the multi-step process of exiting the extraordinary monetary policy.   Some observers suspect that first tapering could be announced at the FOMC meeting late this month.   Color us very skeptical.  

The consensus is for the first announcement to be made in September and implemented in October, whereby it would reduce its long-term asset purchases to $65 bln a month, down from $85 bln (which means still translate into $450 bln of purchases here in H2).  It is expected to stop its purchases completely in mid-2014.  Indicative market prices, like the Fed funds and Eurodollar futures suggest a little more than a 50% chance of the first hike is priced in for late 2014. Even if the interpolation from market prices is inexact, there is little doubt now that the Fed will be the first of the major central banks to exit.  

The ECB has innovated.  It previously chose not to pre-commit.  This was a cornerstone of its communication policy.  This was a way to preserve and maximize its options.  Yet, sometimes as the game theorists remind us, denying oneself options is also an important part of strategizing and sending a still powerful signal.  The ECB has indicated that official rates will remain at current levels or lower for an extended period of time.  That precise measure of extended period of time is really of little matter presently.  It is clear that it means no refi rate hike until mid-2014 at the earliest.  Judging for the euribor curve,  the market does not appear to be anticipating an increase until closer to mid-2015.  

The December 2014 Euribor futures contract is difficult to read.  The 60 bp increase in the implied yield from mid-May through late June was not a sign of rate hike expectations, but it appeared to part of a larger market reaction to the tapering talk in the US.   Draghi explained that the ECB's innovation was in part a reaction to that backing up European interest rates.    The market understood and from the ECB meeting last week through earlier today, the implied yield on the Dec Euribor futures contract fell almost 25 bp.  

While we think that Fed's tapering may take place later than consensus and a hike in the Fed funds rate is unlikely in 2014, we also suspect the market does not appreciate the risk that the ECB still has to ease monetary policy   Although the ECB has not ruled out another LTRO or a negative deposit rate, we suspect another 25 bp cut in the refi rate is the most likely course.  The timing still appears a couple of months off.  We would pencil it in for October.  

We continue to come back to how well short-term interest rate differentials track the euro-dollar exchange rate.  Consider that since the global economy bottomed in mid-2009, the US on average has offered 17 bp less than Germany on two-year money.  Today it offers 28 bp, the most in three years.  The euro has averaged about $1.3480 over this time.  Today it is near $1.28.

The CFTC released the latest Commitment of Traders report earlier this week, as the July 4 holiday delayed the release.  The data is more dated than usual.  However, it is revealing to note that in the week through July 2, that it in the run-up to the ECB meeting and the US jobs data, the net speculative position swung from net long 17.4k contracts to being short 16.1k.  This shift, though reflect longs liquidating more than five times greater than the new shorts being established.  The gross short speculative position of 75.4k contracts, is less than a third of the record set last year of a little more than 250k contracts.  

The divergence between the US and European economic activity, the relative trajectory of monetary policy, not very crowded market speculative positioning underpins the case for the weaker euro.   The US policy mix itself is will be moving in a more supportive direction for the dollar.  This year's tight fiscal loose monetary mix will give way next year to somewhat looser fiscal policy (not only Federal government, but the contraction of state governments appears nearly over too) and somewhat less loose monetary policy.