Over the past year, there has been no stauncher supporter of the short-EUR trade than Goldman: so staunch in fact that Goldman's top trade for 2015 was basically a short EUR trade (which however ended up being a total loss for anyone who put it on because the EUR did not drop as fast as Goldman had expected as we noted last week).
Which is why we were surprised that with the Euro plunging again today in the aftermath of the latest ECB trial balloon via Reuters, and sliding to a new 7 month low below 1.05, Goldman came out with a sales piece in which it is said that the firm has "reduced our short in the euro versus US dollar as central bank actions are increasingly priced in to both markets." In other words, unlike a year ago, this time the EUR had fallen faster than Goldman expected.
To some, this immediately meant that the ECB may get cold feet about engaging the full bazooka, Reuters' earlier trial balloon notwithstanding, and made traders far more focused on the word of ECB governing council member Ardo Hansson who this morning told MarketNews that he "Sees No Reason For Monetary Easing at Dec Meeting." Could Draghi have been engaging in nothing more than the latest mega bluff? The question was enough to prompt a rebound in the EURUSD back over 1.06.
But is Goldman turning bullish on the Euro (and bearish on the USD)?
Here is the full reasoning provided by Goldman's Robin Brooks explaining the bind the ECB finds itself in currently, which it still thinks the EUR is heading to 0.95 by Q1 2016, and a whopping, and US multinationals crushing 0.80 by the end-2017.
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From Goldman's Robin Brooks
On the day of the last ECB meeting (October 22), we published an FX Views where we argued that EUR/$ would go to 1.05 in the run-up to the December meeting. We are approaching that level, which makes it natural to ask what is now priced, and if there is scope for a dovish surprise on December 3.
We address these questions in this FX Views, but also the big picture, which we think is important. The big picture is that ECB QE, since its announcement in January, has had a troubled history, with volatility in long-term Bund yields – the Euro zone safe-haven asset – far above that of JGB yields (Exhibit 1).
That volatility has impaired a key transmission channel of QE, which is to push Euro zone investors into risk assets and thereby boost growth, and is in our minds the main reason why EUR/$ went back to 1.14 in May (Exhibit 2).
Next week’s ECB meeting is therefore more than just the usual policy decision. It is about fixing some of the damage from the summer and “doing it like you mean it”. We think that dimension is underappreciated and means that, together with the low risk appetite typical for this time of year, the hurdle is low for a dovish surprise on December 3. We continue to expect EUR/$ to head into the ECB at 1.05, drop 2-3 big figures on the day, and then fall to parity by end-December, aided by a Fed lift-off. As risk-taking resumes in January, the divergence trade should pick up steam, with a possibility that our 12-month forecast of 0.95 for EUR/$ could be reached by end-Q1.
As we wrote ahead of the October meeting, conflicting narratives have emerged about ECB QE. One view is that its main purpose is to anchor periphery sovereign spreads, while allowing the yield curve on Bunds to remain somewhat steep. That accomplishes the dual objective of safe-guarding the periphery and helping investors in Germany, who continue to benefit from some roll-down.
Another view, however, is that the Bund sell-off in May and subsequent volatility disrupted one of the main channels through which QE is supposed to work. That view says that the purpose of QE is to stabilize yields on the safe-haven asset at a relatively low level, where the emphasis is on “stability” rather than a specific level. This sets in train a portfolio rebalancing out of the safe-haven asset into risk assets and other currencies, with positive repercussions for growth. We think the Bund sell-off, so quickly after the start of the program, is a key reason why EUR/$ bounced from 1.05 to 1.14 by May and at times went above that. From our perspective, ECB QE has fallen short in signaling commitment to the portfolio rebalancing channel, in particular since the Bund sell-off in May came amid signs that the Bundesbank – the key stake holder in the Eurosystem – was reducing the maturity of its purchases. This matters for next week, where there is a larger agenda: repairing some of the damage to ECB QE from the summer.
We think there is ample room for President Draghi to push a dovish agenda next week. After all, the debate over ECB policy suffers from what we think of as “Stockholm Syndrome”, where excessively tight policy for too long has conditioned markets to argue for more of the same. With real GDP still below its 2008 peak (Exhibit 3), it is likely that the output gap is bigger than the consensus 2-3 percent (IMF, OECD and European Commission all have estimates in this range). The degree of slack, even accounting for things like hysteresis, is likely to be large, which is also what shows up in our work on the Phillips curve, where inflation is running below what it should be given the unemployment gap. In fact, given the inflationary impulse from the Euro weakening trend since mid-2014, underlying inflation in the Euro zone is likely even lower. We see current consensus for EUR/$ – whereby the cross drops near parity in December but then moves higher again – as embodying this “Stockholm Syndrome” and ignoring the reality that the divergence between the US and the Euro zone is very real and large. This is why we continue to see EUR/$ in a big weakening cycle, reaching 0.80 at end-2017.
With EUR/$ at current levels, markets are pricing around 15bp in an additional deposit cut and a modest amount of further balance sheet expansion. This is our view because the two big figure drop in EUR/$ on October 22 (the last ECB meeting) priced a 10bp deposit cut and the one big figure move lower on October 23 priced a modest amount of further balance sheet expansion, where we have in the past shown that a one big figure drop in EUR/$ maps roughly into EUR100bn in additional QE. We attribute the bulk of subsequent moves lower to the October 29 FOMC and better-than-expected payrolls (November 6), so that expectations into next week remain relatively low (Exhibit 5). In short, we think the seven big figure drop in EUR/$ since before the October 22 ECB meeting breaks down into three big figures due to the US and four from pricing additional QE easing, which we see as modest. We certainly do not think that surveys for expectations into next week, which are typically for a one year extension of the existing program (i.e. an expansion of the QE program north of EUR 500bn), are reflected in current levels of EUR/$. This is consistent with our read of positioning, where speculative shorts in the CFTC data are now two-thirds of the way to their Q1 peak (CFTC shorts tend to lead EUR/$, likely overstating Euro shorts in the broader market), while option skew (Exhibit 6) remains modest. All this suggests to us that the hurdle for a dovish surprise on December 3 is low. But, as we stress above, what really matters is the big picture. ECB QE so far has a troubled track record. This meeting is about fixing that.
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So if Draghi pulls a "Draghi" on December 3, and stuns the market by admitting he merely jawboned the ECB's "assured" easing to death, with the EUR now pricing in both a 15 bps rate cut and more QE, and thus making any actual by the ECB meaningless (and why should the ECB actually launch a bazooka round when jawboning is enough) you have been warned.