Goldman's Latest EURUSD Outlook

Goldman's Themistoklis Fiotakis has released the firm's latest EURUSD outlook. And while the most amusing part of the note has nothing to do with FX but with the firm's ongoing attempt to bankrupt clients by holding Greek bonds ("Stay long 30-yr Greek GGBs, opened at 54c (ask) on 03 September 2010, for a target of 65c and a stop on a close below 50c, now at 53.6c (bid).") we will cut to the chase: Goldman is still calling for 1.50 on the EURUSD, driven by dollar weakness and increasing European interest rates (which will surely succeed in bringing the EUR to infinity, and then promptly lead to the destruction of the currency when half the European continent files for bankruptcy). But that is irrelevant: what is important is that due to some regression model thingy, the EUR has room to run, or in Goldmanese: "Given that this simple model has an R-squared of 74%, a significantly high reading for a regression in changes, it is safe to argue that our factor analysis captures the largest part of the EUR variation."

1. Overview

Despite the S&P closing flat after a mostly negative session yesterday, Asian equities traded mostly on a negative tone overnight, while European equities are trading more mixed this morning. The EUR continues to hover at levels slightly below 1.45, while US 5yr treasuries are trading around 2.19, a few basis points lower than yesterday.

On the data side, Chinese GDP came in very close to our forecasts at 9.7% yoy. Broader activity data appear to indicate that domestic activity has recently gained some momentum as money and credit growth have also loosened in recent months. At the same time, CPI accelerated at 5.4%yoy from 4.9% in February. The CNY continues to appreciate at a faster pace, benefiting our trade recommendations. India CPI came in at 9% yoy, beating consensus expectations of 8.4% and leading to a sell-off in local fixed income.

Overnight, in our publications, we reiterated our near-term cautiousness on commodities and, along similar lines, we discussed our asset allocation views in the latest GOAL publication. In our latest European Weekly Analyst, we examined the strength of the European recovery: although the ECB looks set to continue raising rates this year by 50bps, we expect the sizeable output gap combined with declining headline pressures to slow the pace of tightening in 2012. We see the ECB’s refi rate reaching 2.5% by end-2012.

In terms of data today, keep an eye on the composition of capital inflows into the US via the TIC data release. The empire manufacturing survey will also be interesting to watch. The University of Michigan consumer confidence survey, however, will be the key release of the day; it will be interesting to see if higher oil prices have further pushed down consumer confidence and boosted inflation expectations.

2. The EUR Rally; Primarily a Reflection of Dollar Weakness…

Since its trough on January 7th at 1.29, the EUR/$ has appreciated by 11.4%. This rally has been in line with our broad views on the USD and the EUR. In addition we have recommended two long EUR/$ trades throughout the course of the rally, both profitable. The most recent EUR/$ trading recommendation is still live and we are currently trading 3.6% short of our target level of 1.50.

Understanding the key drivers of the EUR move will help us assess the tactical risks around it as well. For that reason we use our “FX Betas” framework to break down the recent EUR strength to the macro factors that have driven it. 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.

According to this simple analysis, the EUR appreciation year-to-date has been, by and large, a dollar move. Out of the 15 big figures that the EUR has risen by since the January 7th lows, 9 can be attributed to the shift in the USD TWI. This confirms our focus on the dollar direction as the key macro theme in FX space and the notion that the EUR tends to trade as the “anti-dollar” more often than not, mirroring to a large extent moves in the USD TWI.

As discussed in the most recent FX monthly publication, structurally we remain dollar bearish (and EUR bullish as a consequence) as long as the three key macro pillars of our view remain in place; i.e. as long as the FED maintains its accommodative policy stance relative to the rest of the world, the US trade deficit remains wide and the financing of the external deficit remains insufficient.

That said, in the near term, the risk is that softer price action in risky assets may trigger dollar strength. The prevailing correlations continue to indicate that the dollar tends to underperform at times of strong price action in risky assets. And as Noah Weisberger and Kamakshya Trivedi have pointed out, over the last few trading sessions, the cyclical sectors of the US equity markets have underperformed, indicating possible concerns over near-term growth trends within the equity market.

3. …But Also Driven by Higher EUR Interest Rate Expectations.

The second most important driver of the EUR/$ since its January lows has been the re-pricing of front end European interest rates. The shift in 2yr EUR swap rates accounts for about 6 big figures of the 15bps EUR rally. Together with dollar direction they account for the EUR move in full!

Of the 86bps move in 2yr EUR rates, 25bp reflects an actual ECB hike and the rest reflects a shift in policy rate expectations towards earlier hikes in the remainder of the year. Our view remains that the ECB will hike two more times this year, confirming the shift in expectations. However, as Francesco Garzarelli and Mike Vaknin have recently argued, the market is now pricing in our views to a very significant extent. In fact, we continue to recommend receiving EUR rates (vs CHF rates) as we see less space for European rates to go significantly higher from here.

In our framework, this means that EUR/$ will likely receive less support from European rates going forward. And if European rates were to decline, such a shift could prove to be a source of vulnerability for the EUR/$. Watching Global and European data and monitoring the market’s growth expectations and inflation data will be key along those lines.

4. Speculative Positioning Has Probably Been Less Important of A EUR/$ Driver.

Interestingly, the other variables in our model are insignificant both in terms of statistical inference and in terms of actual contribution to the EUR/$ move. By itself, this is an interesting fact.

    * First, it implies that speculative positioning has not been a key driver of the EUR/$ move since January, at least as far as risk reversals can capture such positioning as a proxy.
    * Second, the impact of US rate shifts has been very small. This helps explain how both our long EUR/$ recommendation and our short US 5y rate recommendations appear to be working at the same time.
    * Third, the impact of risk sentiment on the EUR appears to be small. However, a significant chunk of this is captured by shifts in dollar direction as we argued earlier.

5. Still Room For the EUR/$ to Reflect A Declining Fiscal Risk Premium.

Given that this simple model has an R-squared of 74%, a significantly high reading for a regression in changes, it is safe to argue that our factor analysis captures the largest part of the EUR variation.

Intuitively, however, one factor not fully captured in our model is the decline in the fiscal risk premium on the EUR. In our commentary, we have highlighted this as one of the key catalysts for EUR strength. In early January, the EUR/$ exchange rate incorporated a significant premium associated with the European fiscal crisis. Given that spreads for Spain and Italy, the more systemically important countries in the Eurozone periphery, have contracted since, one would have expected the EUR to receive an extra boost from this. Interestingly, our analysis does not point to a strong outperformance of the EUR relative to the factors included over that time frame. It is possible that the increase in front-end interest rates is capturing this decline in systemic risk, with the decline in fiscal risks allowing the ECB to turn more hawkish. That said, in the near term, it may also be the case that the EUR has space to rise further as the associated risk premium declines.

6. Current Trading Views

The following trading ideas from the Global Markets Group reflect shorter-term views, which may differ from the longer-term ‘structural’ positions included in our ‘Top Trades’ list further below.

In FX:

1. Stay short $/CNY via 1-yr NDFs, opened at 6.7550 on 10 June 2010, and a trailing stop of 6.70 for the $/CNY spot rate, now at 6.5000.

2. Stay long EUR/TRY, opened at 2.1620 on 9 February 2011, with a target of 2.35 and a stop on a close below 2.09, now at 2.2011.

3. Stay long RUB against a basket of EUR (45%) and USD (55%), opened at 33.68 on 1 March 2011, with a target of 31.31 and a stop on a close above 34.71, now at 33.8991.

4. Stay long EUR/$, opened at 1.4085 on 18 March 2011, with a target of 1.50 and a stop on a close below 1.35, now at 1.4474.

5. Stay short $/MYR, opened at 3.066 on 31 March 2011, with a target of 2.90 and a stop on a close above 3.08, now at 3.0595.

6. Stay short $/PHP via 1-yr NDFs, opened at 43.11 on April 7 2011, with a target of 41.50 and a stop on a close above 44.50, now at 43.316.

On Rates:

1. Stay long 30-yr Greek GGBs, opened at 54c (ask) on 03 September 2010, for a target of 65c and a stop on a close below 50c, now at 53.6c (bid).

2. Stay long 10-yr Spanish Bonos vs. Italian BTPs, opened at 54bp on 25 February 2011, for a target of 0bp and a stop on a close above 80bp, now at 61.7bp.

3. Pay 5-yr Swiss swap rates vs Euroland, opened at -137bp on 4 March 2011, for a target of -100bp and a stop on a close below -152bp, now at -139.9bp.

4. Stay short 5-yr US Treasuries, opened at 1.936% on 18 March 2011, for a target of 2.50% and a stop on a close below 2.0%, now at 2.20%.

5. Pay 5-yr Korean swaps, opened at 4.04% on 21 March 2011, for a target of 4.40% and a stop on a close below 3.80%, now at 4.10%.