2011 was the year of the EURO-bear, and yet although we started the year at 1.3290 and closed the year at 1.2960, the EUR/USD's average for the year was 1.3920. Indeed, many investors lost money being short the EUR/USD compared to being long, despite the dire predictions that emanated from all directions. Throughout 2011, on the most part I maintained a long bias in the EUR/USD. The high was 1.4940, and the low was 1.2858.
Investors following my long strategy from the start of 2011 would at most have made 12.4%, and at most lost 3.45%, even though the end result was a lower EUR/USD. There were fewer opportunities for the short EUR/USD investor to be profitable, unless they were willing to hold positions that went up to 8% against them.
The start of 2011 saw a modest short position in the EUR/USD according to the IMM data, a position that was 1/6th the short position today. Positioning is pointing to a market that is short anticipating ratings downgrades across Europe, specifically France. Positioning in anticipation of the US downgrade proved incorrect, as indeed I believe it will be for a French downgrade. In a world that offers few alternatives for yield, I believe European yields that are set by the market will win out in 2012 over US yields that are largely set by the US Federal Reserve.
The largest question for 2011 that no-one wants to answer is why the EUR/USD, despite all its perceived short-comings, did not collapse as so many predicted at the start of 2011. I will try to answer this question, noting that it is harder to answer the largest question than to join the crowd in calling for calamity. The market spent the better part of 2011 discussing the European debt crisis. The out-trade here is that it was not a European debt crisis, but rather a country-specific debt crisis. German 10-year yields dropped from 3.00% to 1.84%. French 10-year yields dropped from 3.36% to 3.13% and Spanish 10-year yields dropped from 5.45% to 5.04%.
The debt crisis was in peripheral states like Greece and Portugal, and also in the core, Italy, where 10-year yields jumped from 4.7% to 7% by the close of the year. The EUR/USD did not collapse because European investors did not abandon Europe, rather they moved from Italian, Greek and Portuguese Bonds into the relative safety of Germany, France and Spain. If you think of Europe as a bucket filled with investors, they simply moved over to the safe side out of the riskier side, rather than jumping out of the bucket entirely. If there was a European debt crisis, then German 10-year yields would not be yielding the same as US 10-year yields.
The construction of the EURO has its downfalls, and its benefits. When one country does poorly, other countries benefit. German Chancellor Merkel has made it very plain that the perceived weakness in Europe has done wonders for German exports, and indeed for the funding costs for German institutions. As depositors fled Greek banks and debt, they poured money into German Banks and German debt, and as the EUR/USD dropped on Greek weakness (a country that only makes up around 2.8% of the Eurozone's GDP), German industry benefited by gaining market-share from the US in industrial trading markets. As Greece and Portugal have entered into austere times, Europe has become China's number one trading partner, taking the US out of that position. Now if all markets in Europe weakened together that would be another story, but as it stands, the diversity of the region means the overall GDP of Europe has changed very little.
2012 will for Europe be a defining year. By March we will have the details on the European Fiscal Union that will modernize the social states that remain with high debt to GDP. Debt levels will be reduced significantly, be it through haircuts that remain undecided in Greece, or else through severe cut backs in spending combined with the privatization of state assets - state assets that for the time being are inefficient users of tax revenue rather than privatized efficient payers of tax revenues. There comes a time when borrowing your way to prosperity must come to an end, at that moment the root of the problem needs to be addressed.
Merkel and French President Sarkozy have decided this is the time. Their bravery will be rewarded. As the world's reserve currency, the US has decided it can continue to spend its way to growth. That is certainly possible as long as others are willing to lend to you, and for the moment it would be foolhardy to suggest that that would change anytime soon. However, China continues to express its displeasure with US's fiscal state. They will not withdraw their support of US treasuries, however, they will reallocate future purchases of treasuries to their largest trading partner - Europe - once they feel that Europe has its house once again in order.
How many times did we hear in 2011 that US equities were up because of stronger US data, and down on European debt concerns? Often. Yet, when we look at the performance of US financials against European financials for 2011 there is a disconnect. The largest US bank - Bank of America (BAC) - was down 58.13%, while Deutsche Bank (DB) was only down 26.28%. Morgan Stanley (MS), Goldman Sachs (GS) and Citibank (C) were all down between 43.9 and 45.6%, while BNP and Natixis were down 36.66% and 39.64%, respectively. Given that the world was apparently moving on a European debt crisis, why did US banks under-perform their European counterparts?
Yes, Europe has a tough year ahead of it, one that will be further filled with the political theater of confidence votes, summits and uncertainty, along with the economic reality of lower growth in austerity-driven nations. However, when I look at the EUR/USD I look at Europe against the US. This differs from many sell-side analysts. Indeed, we spent a good amount of time in 2011 discussing with the sell-side their calls for the EUR/USD, and in every instance were told that they do not take the state of the US into account when forecasting the EUR/USD. Note that despite the dire predictions for Europe in 2012, and the few outliers looking for 1.1500 or even parity in the EUR/USD by the end of the fourth quarter, Bloomberg's median forecast is looking for 1.3000 in the EUR/USD by year-end...75 pips higher than where we sit at the moment.
Once again, the trade I recommend for 2012 is for investors to be long the EUR/USD. Market fear has concentrated speculative short positions to their highs, at a time when Europe has acknowledged and is actually dealing with their problems, in their own meandering way. If the EUR/USD could only manage to drop 2.5% over 2011, when Europe was coming to grips with their dilemma, then looking for a drop in 2012 may be foolhardy. In the US, 2012 is an election year.
Many point to the fact that the US equity market goes higher if a Democratic government wins re-election, or if it is voted out and replaced by a Republican government. The US equity market has traded lockstep with the EUR/USD for much of the year. After all, with little growth in the US, overseas markets continue to be a significant driver for US companies revenues. While moves lower in the EUR/USD don't make that much difference to US companies, it is the ripple effect that has tremendous consequences.
When the EUR/USD moves lower, the USD rallies significantly against emerging markets currencies ex-China. A drop in the EUR/USD corresponds to a steep move higher in USD/BRL and USD/MXN, and much of USD/Asia. Uncertainty that is reflected in short EUR/USD positions is amplified through the ripple effect, as monies are withdrawn from Emerging Markets. When US goods become more expensive to Brazilians, they will look to buy from elsewhere.
I have written about President Obama's overriding goal to double US exports over 5 years. That goal was set in 2010, so there are 4 years left, and I am convinced that this will not happen with a stronger USD. I think it is unlikely that the ECB will begin massive QE in 2012. Their mandate is price stability, not employment. I do think it is likely that countries having difficulty may institute a primary dealer program much as the US did in 1960. In that scenario, any debt not picked up by the market would be retained by the banks. Banks would be able to buy this debt in part with monies borrowed from the ECB.
Markets jumped on the fact that Germany failed to fill an auction in the later part of 2011; remember, Germany does not have a primary dealer system, so comparing their auction to one in the US is like comparing apples to oranges. Much was made over the past 2 weeks of the 3-Year ECB LTRO, and how banks were keeping the monies on the ECB's balance sheet. Well, of course they did. No one takes on new positions at the end of the year, however to be sure, there is now a considerable war-chest of capital held by European Banks at the ECB that could be put to work in the right environment. As to market fears that Italy will leave the EURO, I have not heard any policy-maker in Europe voice that concern. Italy will be able to weather this storm and will come out the other end in a much stronger position.
In mid-November I pointed out the oversold position in the 3M EUR/USD 25-delta risk-reversal space. Back then puts were pricing 4.4 vols over calls. They are now 2.55 vols over, a 42% move. In the past a move such as this has seen a significant short-squeeze in the EUR/USD. Given the extreme short EUR/USD position according to the IMM, the EUR/USD cross looks ripe for a short-squeeze.
This could come from an announcement from the IMF that they have created a EURO-zone specific fund that will be funded by non-European G20 countries. The IMF's Managing Director Christine Lagarde has been quiet on this front, however, note that all countries outside of Europe continue to discuss putting monies into the 'European Fund' at the IMF. It could also come following ratings downgrades in Europe... Sell on the rumor, buy on the news. Either way, it will come, and the move will be swift and painful.
My passive trade for 2011 was to be long EUR/USD and gold. At its worst point it was down 7%; at its best, up 42%, closing the year up 11%. Given the QE expected in Japan, the UK and even in the US, I continue to like this trade, and recommend it for 2012. Fears of European collapse seem overblown relative to the direction I see Europe moving in through 2012. Certainly there will be bumps in the road, but that light at the end of the tunnel is not a train.