After The Fed: A Good Time To Short The EUR/USD?

by: Evariste Lefeuvre

The ECB is less dovish (Governing Council member Nowotny remarked earlier this week that there were no realistic prospects for a rate cut and that " we may have to live with" a strong Euro) while the Fed is perceived to be slightly more hawkish (the FOMC statement mentioned that economic activity has continued to expand; no mention of the "tightening of financial conditions"). Would this be enough to accelerate the recent weakness of the EUR/USD?

The series of charts below show that the recent disconnect between the bond and the FX market is calling for a weaker EUR/USD.

1. The 2-year sovereign yield spread suggests that the EUR/USD should stand at 1.35;

2. The spread of the short end slope of EUR and US swap curves would also suggest a level between 1.33/1.35;

3. The Tnote/Bund spread is also suggesting that the pair should have a weekly decline of 2.5%; and

4. The changes in relative money market curves are also bearish for the pair.

Beyond the fixed income markets, other risky asset markets are sending bearish signals. The message from relative stock performance confirms that the EUR/USD is too high. If, as the current trade favoring an outperformance of European stocks is still valid (almost crowded but not completely still if you compare US and Eurozone ex Germany P/E levels), then there is even further way for a decline in the EUR/USD.

The only signal that the EUR/USD at its current level is still well priced is the PMI spread between the Eurozone and the US. The US may suffer from a temporary blip due to the temporary impact of the shutdown on the US economy but I do not foresee Eurozone activity surging during the next few months relative to the US.

Of course, there are some signs that may be slightly bullish for the EUR/USD. For example, if you believe that risk on/ off is back, then the EUR/USD and the S&P 500 should be correlated once again and the chart below would suggest that the EUR/USD is too low (or that the S&P 500 has some downward space for a slight correction). But If I hade to identify the current regime I would clearly suggest that we are much more in a "QE trade" regime than in a "risk on/off" regime.

In addition, the current account balance of the Eurozone is still above 2% of GDP, which is clearly not compatible with a weak currency. But this is more of structural tailwind for the pair than cyclical.

Bottom line: Structural factors and the good old risk on/off approach would call for a continuing positive trend for the EUR/USD. Yet, messages from the fixed income market and the relative (past and expected) performance of US and European stocks would call for a pause in the 8% rise that the EUR/USD has registered since mid-July - even before the medium run technical resistance of 1.40 is reached.

The biggest risk to this scenario is clearly the forthcoming speeches of FOMC members as any further decline in the US treasury yields would definitely bring the EUR/USD much higher if the current correlation regime (taper/QE rather than old-style risk on/off) still holds.

If you have a year-end horizon and believe as I do that the Fed will drive US Treasury yield higher by then, stay short EUR/USD (NYSEARCA:FXE).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.