Time To Short The Franc... With The Euro

Includes: FXE, FXF, UUP
by: Dr. Duru

The Swiss franc has had a floor against the euro set at 1.20 for about 15 months. During that time, there was a stretch of about five months where EUR/CHF traded right on top of that floor. Traders never made a strong attempt to test the resolve of the Swiss National Bank (SNB). Based on trading over the past four months, I think that test will not come anytime soon. Indeed, it looks like it is time to get more aggressively bullish on EUR/CHF.

The euro is looking stronger than it has looked in many, many months against all major currencies. On Thursday, Mario Draghi, president of the European Central Bank (ECB) gave markets every reason to cling to hope for the eurozone. While economic conditions remain poor, Draghi insisted that the eurozone is "…now back in a normal situation from a financial viewpoint" and in the second half of the year "…economic activity should gradually recover" (see Reuters article: "HIGHLIGHTS-Draghi comments at ECB news conference.") He punted on the tremendous unemployment problem in Europe by suggesting the problems are structural and thus out of the reach of monetary policy. However, if economic conditions are to start turning around later this year while financial conditions have normalized, then, presumably, unemployment must be about as bad as it can get now. This will surely be the logic used to justify bullish positioning in the eurozone.

While Draghi notes that risks remain to the downside, the risks are not new and much milder than the palpable risks felt just a year ago that the euro could soon break apart…

"The risks surrounding the economic outlook for the euro area remain on the downside. They are mainly related to slow implementation of structural reforms in the euro area, geopolitical issues and imbalances in major industrialized countries. These factors have the potential to dampen sentiment for longer than currently assumed and delay further the recovery of private investment, employment and consumption."

With tail risks gone, the euro has rallied strongly against all major currencies. So, the euro is a good candidate for using to short many currencies. I like the franc as a target because 1) the floor looks like it will hold firm, 2) the SNB continues to insist that the franc remains very overvalued and will presumably continue to work on behalf of franc weakness, and 3) perhaps most importantly, the franc carries a much narrower range of upside surprises than other currencies. Number three is a result of the franc already absorbing much of the fear of euro destruction.

The U.S. dollar is a great example of a currency which should be weaker but carries plenty of upside risk. The U.S. dollar has proven incredibly resilient after QE3 and additional accommodation by the U.S. Federal Reserve by tying asset purchases directly to employment levels. This suggests to me that there is an upward bias waiting for a catalyst. For example, given the yen's rapid decline and fall from favor, the U.S. dollar could easily become the overwhelming choice for "safety" whenever the next market scare occurs.

Four months since QE3, and the dollar index has still gone nowhere

I have noted in the past that I would look to EUR/CHF for a sign that any strength in the euro is sustainable. When the euro surged against the franc in early September after a five month slumber, I prepared to drop my bearishness against the euro. The surge in EUR/USD past the 200-day moving average (DMA) ended my bearishness. Since then, the 200DMA has served as good support and more recently the 50DMA has provided even stronger support for the euro against the U.S. dollar.

The euro breaks out against the U.S. dollar

And now EUR/CHF has surged to fresh 52-week highs along with EUR/USD's 9 or 10-month high - seemingly confirming euro strength with an exclamation point.

Once again, the euro surges against the franc

Source for charts: FreeStockCharts.com

EUR/CHF is now even more over-stretched than it was in early December or mid-September, so I expect some kind of pullback any day now. I want to buy that dip: the "fat franc" is singing the euro's praises.

Be careful out there!

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in FXE over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.