Citi On The Euro's Surprising Resilience And Why "At These Prices We Are Not Buyers"

Tyler Durden's picture

While over the past week we finally got confirmation that while the Swiss franc reserved its place at the top of the foreign exchange pantheon as the last flight to safety currency (with dollar concerns expressing themselves in the form of accelerating DXY selloffs predicated by fears of QE3 should oil continue rising higher or the world economy deteriorating), the one surprising discovery has been the stunning resilience of the Euro in light of relentless bad news. We have already noted our concern that March is rapidly coming, and brings with it a vicious calendar of European political upheaval and debt maturities, which should only be ignored at the peril of other people's money. Confirming our Euro-skepticism is Citi's Steven Englander who has released an extended note earlier titled "EURUSD - why so strong" which seeks to explain why the EURUSD is not trading a few hundred pips lower. Englander's conclusion: "we still find it hard to sweep away sovereign issues, especially if private sector positions continue to creep up. Under a benign global outcome, we continue to see better currencies to buy than the EUR, and under a not-so-benign outcome, we expect that the run-up in risk aversion will be a significant EUR negative. At these prices we are not buyers." Yet someone is...

Englander's summary of recent developments:

The euro has rallied so far this year and has kept its gains despite market (and our) skepticism that sovereign debt issues have been resolved. The 2011 rally is driven by incentives for reserves diversification, rate differentials moving in the euro’s favor, rebuilding of long EUR positions and improving global risk appetite. We find that the EUR is reasonably priced given the above factors. However, it is less clear that these factors will continue to evolve in a euro-positive direction.

In particular, investors appear to be buying the EUR on the back of increasingly optimistic comments from the ECB about the state of the euro zone economy. But incoming data largely reflect November-January conditions and probably not the conditions that would exist if there was a major oil shock. We think that FX investors may begin to reconsider their optimism.

The EUR is sensitive to a global oil shock because such a shock will likely lead to a reduction in risk appetite, a cutting of positions with respect to risk-correlated assets and slower growth. The major economic risks if these shocks intensify are for capital goods exporters, oil importers, and non-oil commodity exporters – and their currencies. The EUR is sensitive to the first two. More broadly, slower growth and risk aversion would make investors price sovereign debt more negatively, and if that is the direction in which global asset markets are moving, it seems unlikely that the EUR rally would continue.

One tactical reason for the strength of the EURUSD is, as we have repeatedly shown in our CFTC COT updates, that both speculative and structural position in the EUR is no longer short: it appears that the most famous trade of H2 2010 has fallen out of favor.

Many market participants started 2011 holding EUR-shorts. The leg higher in EURUSD on the back of hawkish Trichet comments in the second half of January took some by surprise. The recent path of our daily CitiFX PAIN positioning indicator seems to corroborate this conclusion (Figure 2). PAIN measures the correlation between hedge fund performance and EURUSD returns. The indicator picked up at the start of January as EURUSD weakened but then weakened noticeably later on as the leg higher in EUR seemed to be hurting hedge fund performance. According to PAIN, hedge fund positioning caught up only gradually with the move higher in EURUSD (PAIN started growing again in February as shown in Figure 2). IMM data further suggest that a broader group of FX market investors were caught wrong footed when the EUR started rallying in mid January. Consistent with the PAIN indicator, the IMM data also suggests that there has been a gradual build up in EUR longs which intensified in February (Figure 3).

Europe's biggest risk continues to be its fragmented fiscal policy, and the increasing protests against austerity and banker bail outs, today's Irish vote being one of the bigger risks:

EUR downside risks are still dominated by the situation in the euro area periphery. We have seen and heard European politicians talk about finding a comprehensive solution to the problems of the fiscally weak euro area member states. However, Portuguese funding costs continue to hover close to record highs highlighting the likelihood of Portuguese bailout in coming weeks. While we have seen some correction in Spain-Germany yield spreads, these remain very elevated historically and suggest that some risk remains.

The bailout problem could come to the fore much sooner if the Irish opposition parties stay true to their pledges and demand a re-negotiation of the Irish bailout following a likely victory in tomorrow’s election. Importantly, such demands could be met with firm opposition by countries like Germany where the ruling coalition is desperately trying to improve its standing with an electorate which is turning increasingly hostile to growing German participation in the peripheral rescue effort.

In a zerosum world, is the recent atavism against the (temporarily?) former reserve currency a direct reason for the EUR's resurgence?

Sovereign USD-selling can explain some of the EURUSD resilience…

Fully quantifying the extent to which the EURUSD resilience recently has been due to USD-selling by reserves managers is difficult. Anecdotal evidence, as well as indications that the so called ‘currency wars’ practices and rhetoric of late, seems to corroborate the view that global reserve managers were indeed active buyers of EURUSD recently. There were indications at the start of the year that Asian investors will purchase peripheral assets or participate in the bond auctions of the EFSF. While the indicated amounts were rather small overall, we think they sent a credible signal about the intentions of global currency managers in their (apparently) continuing efforts to diversify away from USD. This interpretation seemed to persevere even as price action in the peripheral debt markets was turning less supportive of that view in February.

One way to gauge the extent to which USD-selling added to EUR-resilience is to compare the relative performance of EURUSD and EURCHF over the last few months (Figure 4). The level of EURCHF is a well known proxy for the magnitude of perceived risks in the euro area periphery. At the same time, USD-recycling seems to be less of a driver for CHF. As shown in Figure 4, EURUSD clearly outperformed EURCHF. This was particularly true over the last few weeks when we saw a renewed widening of the peripheral spreads to Germany (see also Figure 5). The key risk associated with the feed back loop between USD-recycling and EURUSD is that USD selling could come to a sudden stop against the background of sharp deterioration in market risk sentiment. Foreign safe-haven demand tended to pick up during bouts of risk aversion like the two sovereign bailouts in the euro zone in 2010 (Figure 6). This was supportive for USD (see also the EURUSD path in Figure 2).

Englander's bottom line: sell.

The big EUR pluses are the chronic global overhang of USD among reserve managers, the perception of a bias towards easing in US monetary policy, the lack of credibility of fiscal policy, and the perception that US policy is oriented to dollar weakness. Admittedly, these are hefty USD negatives and we expect them to dominate in the long term.

In the shorter term, we think investors are overestimating the EUR’s resilience in the face of global supply shocks. Even in their absence, we still see significant risk that sovereign issues return to the front burner as significant differences become increasingly difficult to paper over. In the past, sovereign pressures have been correlated with German-US spreads moving in the USD’s favor as well, as investors piled into German government bonds. Notwithstanding the price action, we still find it hard to sweep away sovereign issues, especially if private sector positions continue to creep up. Under a benign global outcome, we continue to see better currencies to buy than the EUR, and under a not-so-benign outcome, we expect that the run-up in risk aversion will be a significant EUR negative. At these prices we are not buyers.

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