In his latest note, Jefferies' David Zervos observes something that has been troubling us for the past few weeks as well: namely, whether the relentless plunge in the EURUSD, now down nearly 600 pips from when we said [4]the next EURUSD target could be 1.20, coupled with a far tamer drop in various US equity risk indicators, such as the S&P, means that the EURUSD/SPOO correlation, so well known to most traders, has finally broken down. We doubt it.
What we suggest is that this express elevator to EUR hell, is merely an overreaction on the part of overzealous ultra short-term specs who have been burned so many times shorting equities following central bank intervention, that the only venue left to express bearishness is in the FX realm now that everyone is doing it. Indeed, the most recent CFTC number showing an absolute record of non-commercial EUR spec shorts confirms that it is not a long-term trend, but rather short-term speculators that has pushed the EUR disproportionately lower than where it should be relative to broader risk metrics. Because while equity markets are now obviously pricing in more easing on the part of either the Fed or the ECB, FX continues shorting the only one-way trade that, like a broken ATM machine, prints money day after day. Needless to say, the pain trade will be any appeasing announcement from Europe. At that point we are quite convinced that courtesy of the record number of EUR shorts, which will scramble like manic clown to scramble out of a burning circus all at the same time, any gap in the EURUSD/SPOO arb will be closed momentarily, with a huge overshoot to the upside on any even remotely credible EUR positive news.
Here is what Zervos thinks:
A new Euro/Spoo correlation coming?
One of the many bright trade ideas to start the year was long spoos/short EURUSD. The idea was quite compelling in that the only thing that could truly derail a Bernanke induced spoo rally would be big trouble across the pond - and hence big trouble for the EURO.
And to be sure, the EURO did rally in the beginning of 2012 (from 1.30 to 1.34) as the LTROs took European woes out of the limelight. Of course spoos ripped higher at the same time, and the EURO "hedge" only cost a few percentage points of the double digit risk on rally.
Then, as the European stress began to re-emerge towards the late spring, both the Euro and spoo took a dive. If you shorted 100m EURUSD at the beginning of 2012 and bought 100m spoos, it certainly generated a less volatile, more appealing risk adjusted return trade than just a naked long spoo position. The "hedge" worked nicely in times of stress and didn't cost too much in times of relief. That said, I would still maintain that a long blues position has been a better risk/reward hedge for the spoo. And of course, spoos + blues sounds a lot cooler!
In any case, something smells a little different in the last week or so - the spoo/EURO correlation seems to be breaking down. While spoos have bounced 3 percent off the lows (and are still up almost 6 percent for the year), the EURUSD is on its knees, at the lows of the year (down 4 percent YTD). On the downside, the correlation seems intact. For example, as we watch the market respond to grim news out of the Euroarea this morning - with the Germans admonishing the Spainish on Bankia and proposing gold collateral for Eurobond issuance - the spoo and EURUSD both moved lower. But on the upside in recent sessions, when there is broad discussion of a Eurobond, ESM bond issuance, Euro deposit insurance or ECB backstopping, the spoo heads higher with no meaningful bounce in the EURO.
I would argue that there seems to be a growing recognition amongst longer term investors that the "socialized, federalized and stabilzed" solution to Euro area problems is now being seen "correctly" as EURO negative. But at the same time this solution is fantastic news for global risk assets. Once Europe backstops, federalizes and socializes we can all breath a collective sigh of relief (unless you are a thrifty German saver, in that case you can just start drinking heavily). Importantly, this kneejerk idea that any policies to stabilize Europe will be EURO positive is fading fast - thankfully.
Umm, no. The reason why the "correlation has broken down" for the time being, is that specs have piled in on the EUR short trade, while not daring to get burned when the banks announce something, anything, as can be seen on the chart below, which shows net non-commercial EUR shorts at all time highs, while the E-Mini bearish spec position remaining very tame by comparison.
[5]
Intuitively, when the regime changes, one can bet that the EUR short covering action will be unlike anything seen before. Actually, make that like something seen before: below is a chart showing the nearly 400 pip move in seconds when the expanded QE1 was announced on March 18, 2009 [6].
[7]
Add to this a record number of shorts, and being LONG EURUSD (potentially with an offseting SPOO short for a less balance sheet intensive pair trade) which will easily rip 400-500 pips in the current record EUR short environment, could well be the ABX trade of 2012 for some lucky trader.
There is just the minor matter of timing...