What's Next For The Euro? Two Contrasting Opinions From Goldman And Citi
Wish you had some guidance with the confusion on whether what just happened is good or bad for the EUR and thus for the S&P? Well, don't read this post, which presents two diametrically opposite opinions on what is next for the euro, one from Goldman's Thomas Stolper (not Jim O'Neill or John Noyce, both of whom are massively short the European currency), and another from Citi's Steven Englander. The two couldn't be more diametrically opposite. That said, some of the mea culpas in the Stolper piece (the same guy who got not a single FX call right in 2010) are worth the $0.00 price of admission alone.
From Citi's Englander:
It looks increasingly likely that the Greek austerity vote will pass and this has very much been priced into asset markets over the last two days. What is surprising to us is: 1) the degree to which the EUR has swung on these news and 2) the degree to which the sentiment on the vote has carried global asset markets. We are surprised on the EUR because it seemed very likely even last week that the vote would pass, and even after the vote, the future evolution of peripheral economies and peripheral debt remains highly uncertain. On 2) we have seen equities, rates and commodities all rallying over the last two days. This may reflect the degree to which the European financial system was viewed as vulnerable to a peripheral debt shock, and the degree to which some of the current proposals are viewed as favorable to banks -- the European banks stocks index has rallied by more than 5% since Friday's close.
Looking beyond today, it looks to us as if the EUR good news is well priced in. ECB President Trichet reiterated his 'strong vigilance' comment yesterday and the markets are clearly taking a more optimistic stance relative to sovereign debt. We continue to think that the EUR will have trouble finding additional good news in coming months. The austerity program and the spillover of sovereign default risk across peripherals means that the private sectors in peripheral countries will face intense pressure until sovereign debt is finally resolved -- probably in two years or more. Whether such fiscal and credit market pressure is consistent with the tax revenues that peripheral countries have penciled into their austerity programs is an open question.
The last element remains global risk which has been put to the side over the last few days in the focus on Europe. Our EM economic surprise index has continued to fall in June and is just off two-year lows. The concern on global growth that is related to the impact of EM monetary tightening on EM economies and asset markets, as well as the lagged effects of the earlier run up in commodity prices, remains in place.
And from Goldman's Stolper:
Attribution of recent EUR/$ moves
Having recommended EUR/$ long positions since mid-March, we have been following the turns and twists of this key FX cross quite closely. To state the obvious, while we are still in positive territory with our recommendation the Sharpe ratio and drawdowns are far from impressive.
When trying to analyse short terms swings, we often use our Correlation Cruncher to do some deliberate data mining. Typically we discard any result that looks counterintuitive or spurious but more often than not, our Correlation Cruncher produces intuitive results for EUR/$.
The Cruncher is set up with a variety of possible input variables, which may or may not help create a regression with a good fit. It then goes through all possible variable combinations while trying to optimise according to the AIC criterion. We typically run the procedure with a couple of commodity prices, interest rates, a linear trend and equity indices.
Over the last six months, the best fit is achieved by a combination of energy prices, SPX, 2-year US swap rates, 10-year Eurozone swap rates and a linear trend.
The trend has changed
As mentioned above, we have been particularly interested in the recent swings from late April onwards. The initial correction took EUR/$ from 1.4850 to 1.4000 before stabilising more recently in a range centered around 1.43. So we are really looking at a move of about 5.5 cents on a net basis.
As expected from a deliberate in-sample exercise, the fit is pretty good and we can explain most of this 5.5 cent move with our regression.
With risk aversion generally rising during this period, the S&P GSCI Energy Index and SPX contributed with 3 and 1.5 cents respectively to the depreciation. In particular the SPX coefficient appears smaller and less significant than in similar regressions conducted over earlier sample windows.
Rates markets also rallied but here we have obviously offsetting forces on both sides of the Atlantic. The decline in European swap rates put a substantial 8 cent downside pressure on the EUR, while the rally in US swap markets delivered an offset of about 6 cents. Interest rates therefore contributed with a negative 2 cents net.
Finally, the linear time trend has recently become more clearly and more significantly positive, contributing about 2 cents over the same period. This is a relatively new development and in stark contrast to the period until earlier this year where the sovereign crisis put EUR/$ firmly into a negative trend – even after accounting for the swings in other correlated asset prices. We typically see this trend as a proxy of underlying allocation shifts and balance of payment flows, which are not picked up by other higher frequency input variables.
Taking all these factors together we can explain about 4.5 cents of the 5.5 cent decline since April.
Still a lot more upside
Using this simple analysis to project ahead, it appears EUR/$ may soon continue its uptrend. A scenario that includes an improving cyclical outlook and a renewed decoupling of US rates from the rest of the world would boost the EUR relative to the Dollar, and this is also quite close to our forecasts.
Of course risk sentiment and European rate expectations will critically depend on the Greek developments, but there again we do stick to our underlying view that most of the tensions are about political burden sharing and not really about any threat for Eurozone FX fundamentals.
So now you know: forget everything else you know about capital market and just put your faith in the Correlation Cruncher. All else is just irrelevant signal.
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