Goldman, which some time ago posited a 1.50 target in the EURUSD, is starting to get rather nervous about its recommendation: "We expect the dollar depreciation trend to extend in the twelve months ahead. In the near term, however, recent cross-asset correlations could mean that equity market softness would translate to dollar strength. This could especially be the case in the event that markets start to perceive the recent slowdown in data as deeper and more global in nature. This is not our expectation at the moment. However, given that we are less than 1% away from what was initially considered an ambitious target of 1.50 in our long EUR/$ recommendation, any incremental increase market volatility could significantly tilt the overall risk/reward of the trade. Hence we are watching relevant developments across risky assets closely." In other words, now that the intertim silver "bubble" has popped, the EURUSD may be next to follow, since the key requirement for a market drop, and further monetary easing greenlighting, is unexpected, and not priced in, dollar strength. Based on this Goldman piece, it may be coming very soon.
Our EUR/$ Tactical Risk As It Approaches Our 1.50 Target, from Goldman Sachs
1. Market and Data update
A softer print on the ISM non-manufacturing index added to the evidence from prior weeks of a soft patch in US cyclical data and led risky assets lower. The S&P declined by about 70bp yesterday and closed 1.7% off its recent highs. US yields continued to decline as well and in line with weaker price action in oil, agricultural commodities and also metals. The dollar showed signs of strength against some NJA and LATAM currencies.
However, expectations for the ECB to maintain its hawkish language in today’s meeting, as demonstrated in the ongoing increase in EU front end rates, has supported EUR price action (and EUR based currencies vs the USD broadly speaking). In today’s meeting it will be interesting to watch whether President Trichet signals a July or a June hike; the market assigns an equal probability for a hike in either meeting, roughly speaking – we think July is more likely.
The BOE meeting will also be interesting to follow. In light of recent data softness, we believe that a hike is unlikely before Q4. Initial claims in the US will be key to watch too; and it will be interesting to see whether the recent spike in claims extends.
2. Why we are watching the EUR/$ closely
We are watching the EUR/$ very closely because it represents a significant portion of the FX risk we are recommending to clients. We are not only exposed in EUR/$ directly through our relevant recommendation but also via our long EUR/TRY recommendation. With the TRY just starting to depreciate again vs. the USD, most of the 6% EURTRY appreciation of the last month can be linked back to the EUR. Moreover it can be argued that if the EUR were to trade more volatile, our several short $/NJA recommendations could also face headwinds.
There is another reason why we are vigilant over our long EUR exposure. After a significant 15% rally since January, a large part of which our recommendations have captured, the near-term tactical outlook is becoming more confounded by muddier risk sentiment. Softer cyclical data have triggered more volatile price action in global equities. And our Macro equity team has already moved towards a more defensive direction by recommending closing long XLI/XLP positions and going short the UK consumer basket. Given past correlations, the EUR has a harder time powering ahead during periods of volatile risk sentiment.
3. EUR Still Driven by Dollar Direction (primarily) and EU Rates (secondarily)
In order for us to identify and quantify the key risks to our EUR/$ exposure, we resort to the simple “performance attribution” analysis we ran a month ago in a Daily. Namely, we use our FX Betas framework; FX Betas are simple linear regressions of weekly changes in exchange rates (against the USD) against weekly changes in domestic front end rates (2y rates), US 2yr rates, dollar direction (using the broad USD TWI), positioning (using short-term risk reversals as a risk proxy), and risk sentiment (as captured by the VIX). Cross asset relationships with currencies are typically unstable; over time, sensitivities of currencies to other assets tend to change. So our framework is trying to capture the most recent market sensitivities. For that reason, these regressions are run over a rolling sample of 12 months to reflect current market sensitivities. Every month we present the updated coefficients in our FX monthly publication.
The key results of this analysis have not changed considerably over the last month;
* Out of the 15% EUR/$ appreciation, about 10% can be traced back to overall USD direction. By and large, the EUR/$ move has been a broad dollar move.
* A bit less of the remaining 5% can be attributed back to higher EU front end rates. 2yr EU rates have risen by about 75bp since early January, 25bp of which represent an actual ECB hike.
* Positioning has not played a major role in the EUR move. Although there is evidence (from IMM data for example) that EUR longs have built up to some extent, our analysis argues that it has not been a major driving factor.
* The impact of “other factors” is quite small. To be clear, our model is not all inclusive. There are other factors that may be key in driving the EUR/$, like EU peripheral sovereign spreads or oil prices. The alpha that our model produces, i.e. the average EUR/$ return left unexplained by our variables, is negligible. In practice, our proxies may be capturing the impact of other macro variables to a large degree. For example, EU rates would not have risen so sharply had peripheral tensions not been ring-fenced by policy makers over the last few months. And higher oil prices have contributed to the USD depreciation.
4. Risk from EU Rates Relatively Limited For Now
Higher EU rates have been the key reason why the EUR has continued to make new highs despite negative price action in risky assets over the last few trading sessions. However, in the bigger picture of the EUR rally of the last few months, they account for only 30% of the EUR strength as discussed above and therefore are not the key driving force of or risk to our recommendations altogether.
Of course, this means that a decline in EU rates would still hurt our recommended exposures to a non-negligible degree. That said, the risk of a very large retracement in EU rates is probably not too high at this stage. As our economists argue, EU leading indicators remain very strong and money/credit aggregates remain on an ongoing recovery path. ECB communication continues to point to further pre-emptive tightening to reduce possible inflationary risks on a forward basis. Against this macro backdrop, market expectations for ECB rates are not far from our own forecasts. The market is pricing in 63bp of hikes by year-end while we expect 50bp. No hike is priced for today’s meeting, while the market appears to be pricing an equal chance for the next hike to occur either in June or in July; we think July is more likely.
5. Long Run Dollar Decline Intact; But Near-Term Risk Aversion Could Hurt EUR/$
As we discussed extensively in our latest FX Monthly publication, our broad macro views are consistent with ongoing depreciation pressures on the US dollar. And the recent softening in US data/widening of interest rate differentials between the US and the rest of the world has supported the latest leg of the dollar decline. We expect the dollar depreciation trend to extend in the twelve months ahead.
In the near term, however, recent cross-asset correlations could mean that equity market softness would translate to dollar strength. This could especially be the case in the event that markets start to perceive the recent slowdown in data as deeper and more global in nature.
This is not our expectation at the moment. However, given that we are less than 1% away from what was initially considered an ambitious target of 1.50 in our long EUR/$ recommendation, any incremental increase market volatility could significantly tilt the overall risk/reward of the trade. Hence we are watching relevant developments across risky assets closely.