Over the course of the year I've been arguing that EUR is not a good short against most currencies on the back of a supportive flow picture. About a month ago I talked about the ending of summer shifts and advocated for USD strength against JPY, CHF and EUR. The stars are shifting, finally aligning for more meaningful euro downside. Here are three reasons to turn more bearish EUR both against the dollar and the crosses for the rest of the year.
1. The best of flows is behind us. EUR (FXE) outperformance since the crisis has not been about strong portfolio inflows. Instead, Europeans have repatriated huge amounts of capital supported by domestic risk aversion. The recent improvement in the euro-area PMIs is a big deal however, and is a negative, not positive for the euro. Similar to the yen pre-Abe, the bouncing business cycle suggests at least some partial fresh capital allocations offshore by euro-area investors, on top of any potential cyclical re-narrowing of the euro-area's current account surplus.
2. Positioning is very favourable. The market has completely given up on the EUR [FXE]. Risk reversals (together with the JPY [FXY] and CAD [FXC]) are the least skewed in favor of USD [UUP] strength among the majors, and our own regression-based estimate of portfolio manager returns suggest the flattest position in almost a year. More importantly, the IMM shows a pretty chunky EUR-cross long among leveraged (most likely trend-following) accounts, with the euro (together with swissie) being the largest long when adjusted for open interest.
3. Rate differentials to finally provide a boost. Relative monetary policy perceptions have already shifted in favor of the USD judging by short-end rate differentials. The 2-year rate spread is close to fair value, but the more forward-looking 2y2y spread is already hugely skewed in favor of the USD. The big headwind to more dollar strength has been simultaneous U.S. curve steepening in recent months, causing the de-coupling with the short-end since the beginning of the year (charts). But with the U.S. yield curve slope close to extremes, a strong case can be made for more bear flattening in coming months. Short-end rates are already suggesting fair value below 1.20, so the potential for EUR/USD downside seems large.
In sum, there are good reasons to now be adding EUR shorts into a broad long dollar portfolio. And the meaningful EUR-cross outperformance seen since the onset of OMT may well have come to an end.
Additional disclosure: I remain long USD basket via cash and med term option structures (OTC).