Tuning Out The Euro Negativity Hype

Includes: FXE, UDN, UUP
by: Douglas Borthwick

Over the past nine months, we have been bombarded with negative headlines and research dedicated to why the EUR/USD will collapse on the back of European Peripheral weakness. The research and views offered to us may very well be correct when referring to European Banks, but in no way should then be translated into views in the EUR/USD. Over the past nine months, the EUR/USD has risen from 1.3290 to 1.3800.

A quick search through an institutional investor's mailbox each morning shows the almost one-sided view of Europe's demise. We find this disconcerting. Given most banks and market pundits are continuing to focus on Greek weakness and European inability to act - after all, fear sells - We find it interesting that with the EUR/USD trading at 1.3800 the median bank forecast for the EUR/USD at the end of the year according to Bloomberg is a level of 1.3500, and 1.4000 by the end of 2012.

We also find it disconcerting that while research and tone is very negative on the EUR/USD; it comes at a time when Central Bank and Reserve Manager buying of EUR/USD is increasing. While banks are buying the EUR/USD for policymakers, they are telling customers to go short, given the "end of Europe" is around the corner.

This has been the case for much of 2011. Yet the EUR/USD is higher year-to-date. At first the market focused on Ireland's weakness, stating that Ireland's collapse would result in a domino effect throughout European peripherals. No one talks about Ireland these days; perhaps because they have gone through their voluntary restructuring without causing payouts to the CDS holders, and now the Irish 10-year has outperformed the U.S. 10-year for the U.S. investor year-to-date.

Last week the market appeared to reach a high-pitch in European negativity. We took that as the time to re-enter EUR/USD longs around 1.3560. We prefer to go with the policymaker flow over listening to banks and other pundits who are talking very EUR/USD negative, while based on the median forecast of 1.3500, are really looking for a three big-figure move lower.

We ask the institutional investor this ... Is it better to be short the EUR/USD at 1.3800 looking for 1.3500 when every relevant finance minister is telling you they will protect and defend Europe, and when a package is due to be announced by the end of October? We would argue the trade today is to fade the hype. Being long the EUR/USD allows you to surf policymaker flows while positioning for the inevitable short-squeeze that will ensue as a re-pricing of assets higher ripples through the eurozone. We believe that voluntary Greek haircuts are already priced in, whether in the mark to market, or else through the equity price of European banks. Also priced into the market is a lack of European and global determination to stop the madness.

There are many in the market who have taken positions in the EUR/USD either as a hedge against their U.S. equity positions, or else as an additive to their shorts in the European banking sector. Should the next two weeks play out as we and Merkozy expect; then these shorts will be unwound, resulting in a significant squeeze higher in the EUR/USD. One interesting aspect of the FX market is the amount of positioning that is taken by models and Commodity Trading Advisers (CTA's). What is significant about these players is their lack of interest in the fundamental story, news headline or bank research. They trade on momentum and they trade in size. A move in the EUR/USD above the 200 day moving average currently at 1.4070 will result in a considerable market positioning turn-around.

Over the next few weeks I would expect that EUR/USD longs will sleep more soundly compared to the EUR/USD shorts. Over the next few weeks as the EUR/USD rises, so will U.S. equities. The equity player that sold the EUR/USD as a hedge will have to unwind their position. Over the next few weeks as bank recapitalization plans find stronger foundations - be it come form banks selling assets or taking on new investors - those who are short the European bank stocks will take off their additive shorts in the EUR/USD. Over the next few weeks as the EUR/USD breaks above the 200 day moving average, the model community will turn their short EUR/USD positions to long.

We see the upside on the EUR/USD as having the most room to grow. Those advocating a short position are looking for the EUR/USD at a median 1.3500 level by year-end. Is it worth it to be short the EUR/USD looking for three big figures when the risk is a solution will indeed be found over the next few weeks? Agreed, whatever solution is finalized, it will not be a grand-plan that will fix everything. However this is where relative value kicks in. The EUR/USD defines the relative value between Europe and the U.S. I have yet to see a grand-plan for the U.S. in fixing their longer-term fiscal issues.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.