Citi Explains Why The Time To Fade The EUR Rally Has Come

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Yesterday the short squeeze in the EURUSD brought the pair to within pips of Citigroup's revised stop loss of 1.4260 even as it got even more bearish on the European currency, setting a new target of 1.3150. Today the bank's FX strategists continue their onslaught, stating in a note that wonders how long the Euro-love will last that "The post-summit EUR rally is driven by a continuing squeeze in short risk positions and unwinding of worst fears of financial contagion, rather than improvement in cyclical fundamentals." Here are their full thoughts on why the time to short the pair, and thus the entire EURUSD-driven market, lower.

From Citi's Steven Englander

The EUR rally in the aftermath of the EU summit is not corroborated by the fairly muted correction in fundamental drivers like sovereign debt risk. Indeed, the summit outcome has brought euro zone government spreads just back to where they were in two weeks ago (Figure 1)  and the level of rates in peripherals has barely budged. Measures of relative rate expectations like 2y Germany-US bond yields spreads actually tightened in the last few days.

This seems to be confirmed by our short-term fair value model for EURUSD based on 3M OLS regression cyclical drivers (2y Germany-US bond yield spread), sovereign debt risks (2y Spain-Germany bond yield spread) and risk aversion (Citi short-term MRI). At present the model is pointing at fair value of 1.3850 – well below the current level of spot (Figure 2). The latest correction higher in fair-value seems to be mainly based on the reduction in risk aversion. The result further highlights that important part of the EUR-resilience of late reflects continuing short squeeze in risk-correlated currencies.

The disconnect between EUR-fundamentals and EURUSD is worrying. It means that downside risks could come to haunt EUR once the positioning squeeze runs out of steam and/or sovereign debt risks and cyclical drivers start weighing on the single currency yet again.

First, we remain sceptical that the leveraging solution to increase the EFSF firepower will succeed in lastingly reducing the funding costs for Spain and Italy. The upside pressure on their funding costs could actually intensify if the political crisis in Italy deepens and/or if the prospects for fiscal slippage in Spain grows after the November 18 general elections. In turn this should weigh on the single currency in coming weeks.

In this regard, indications next Thursday by the new ECB president – Mario Draghi – that the ECB is willing to provide further support for the ailing sovereigns in the euro zone could offset some of the negative impact on EUR and risk-correlated currencies. The evidence continues to be that the market is focused on tail risk. When tail risk is reduced we observe an increase in core euro zone rates (Germany, Netherlands, Finland) and lower peripheral rates – this has been EUR positive. 
If peripheral euro zone rates do not come down, growth will disappoint, and pressures will re-emerge quicker than expected. As long as investors are not convinced enough of the reduction in peripheral risk to bring the risk premium down, the downward spiral of poor economic performance and missed fiscal and debt targets is likely to continue.

Second, we think that debt sustainability concerns will continue to haunt Greece even after the voluntary 50% haircuts on privately held debt last night. Importantly, Greece will still have to rely on external financial assistance following the restructuring. In particular, Greece will still need to negotiate the seventh help tranche due by the end of December. With the implementation of additional fiscal austerity measures getting increasingly difficult and, needless to say, with the incentive to do more belt tightening for the sake of avoiding default now largely gone, we suspect that political tensions could grow further. This will make any future negotiations between the Greek officials and the representatives of the troika even more difficult and protracted adding to the headwinds for the single currency.

Another risk is that non-bank investors in Greek sovereign debt do not accept the 50% haircut and are willing to take their chances with default. Even when the 21% haircut was on the table the take-up was disappointing, so with a 50% haircut on offer, there is a risk that the expected funding will not be achieved. 

The euro rally also assumes that the four or five to one leverage on the first-loss guarantee will induce investor buying of Greek and Italian assets. However, there may be some investor concern that a default may be declared a voluntary haircut, as has occurred in the current Greek episode. Hence the insurance value of the first loss guarantee is downscaled by the risk that it will not be honrored, as has occurred in the CDS market.

Last but not least, we suspect that the recently announced European bank stress test results could be put to the test if the markets start speculating that Portugal and Ireland will follow Greece in restructuring their debt. More growth underperformance in the euro zone periphery could be instrumental in fuelling investor fears that a default maybe near. Needless to say, this could easily render the results obsolete adding to the pressure on the single currency.  

We think that the rally in risk and EURUSD could be sustained ahead of the next week. Indeed the upcoming Fed and ECB meetings as well as the G20 summit could prove potentially very supportive for risk-correlated currencies if they signal officials’ willingness to support global recovery and the efforts to deal with the twin sovereign debt and banking crises in the euro zone.

But we also see too many residual loose ends to have confidence that the program won’t unravel or simply deteriorate into a series of mini-crises of funding or growth.

Conclusions

The new information on European policymakers is that they now take seriously the need to avoid a banking or sovereign debt crisis. This would be the main path by which Europe could endanger global growth and financial markets. Absent a financial crisis, risk is likely to rally again, especially given the weakness of policymakers elsewhere to ease in order to fill any gap left by euro weakness.

The indifference of euro zone policymakers to the role that growth plays in making debt paths sustainable is likely to weigh on the euro over time. So we think that some of the eur component of the risk rally will be given back.