A Closer Look at Euro Currency Trading

We think there is room for currencies in an asset allocation program. The Euro, Yen and US Dollar are key currencies to consider.

We favor direct spot FX for currencies and secondarily currency futures. However, for those who do not have or want FX or futures accounts, there are currently ETF and ETN products available to participate in currencies. They are not particularly liquid and are, in our opinion, a poor third choice.

The two EURO products are (FXE) (Rydex Currency Shares ETF) and (ERO) (Barclays ETN). They are poor choices due to low trading volume with consequent delayed execution and high fund expenses compared to spot FX or futures. FX, for example is a $3 trillion per day market, of which the Euro is a significant part, compared to daily trades for FXE and ERO totally less than $15 million.

The 15+ year monthly Euro/US Dollar chart below shows the current exchange rate to be roughly the same as other prior peaks in 1995 and 2005. That may suggest there is more downside potential for the Euro than upside at this point. [dates prior to the rollout of the Euro are synthetic rates based on the currencies that converted to the Euro]

The short-term EUR/USD chart below (May 17, 2007) shows the Euro relative to the recent peak that is roughly the same as the 1995 and 2005 peaks. The current exchange rate is not too far from the last peak.

Given that FX accounts can use as little as 2% margin (50 times leverage) – but also can use no leverage at all – there is plenty of room for gain or loss even with small currency moves.

FXE and ERO are generally not marginable, so that you need a futures or spot FX account to use leverage to magnify gains (or losses) with currencies -- use of leverage is a standard with futures and spot FX.

You also don’t need to go short to be short the dollar, because there are some long positions you can take in an ETF that goes short the dollar against a currency basket. You can go long the Dollar against the currency basket too.

We reiterate that ETFs are inferior choices to working directly in the spot FX market or secondarily the futures market, but ETFs are available choices within stock brokerage accounts as the Powershares dollar index bearish (UDN) and bullish (UUP) ETFs. They are based on the U.S. dollar index (a trade weighted basket of currencies that are key to U.S. trade – Euro 57.6%, Japanese Yen 13.6%, British Pound 11.9%, Canadian Dollar 9.1%, Swedish Krona 4.2% and Swiss Franc 3.6%.).
Fundamentally, the EURO is generally favored as the European economy shows strength and its central banks are raising rates, and many believe the US. Central bank must lower rates to ease the housing problem. Both would increase the Euro relative to the Dollar.

On the other hand, one guru, Marc Chandler, global head of currency strategy at Brown Brothers Harriman recently said in a Barron’s article:

U.S. economic expansion has encountered headwinds from the dramatic fall in residential construction, which appears to be having a knock-on effect in related sectors, and an accumulation of excess inventories in a few other industries, notably autos.
At the same time, many other countries are still enjoying robust growth. Europe’s central banks — not only the European Central Bank and the Bank of England, but also the Swedish, Norwegian, Danish and Swiss central banks — are tightening. So, too, are those in Australia, New Zealand, India, China and some other countries.
... The market is underestimating the duration and magnitude of the Fed’s tightening. The market simply doesn’t believe that a hike is likelier than a cut. …
The risk that few are taking seriously is that by late in the third quarter or early in the fourth, the market-expectation pendulum could swing toward a rate hike. In the same time frame, the tightening in Europe and elsewhere, excluding Japan, may be ending or at least pausing.
All this points to a revival for the dollar by late in the year. … Adding to upward pressure could be speculators’ need to cover their dollar short positions — now at a record level in the futures market. …

If Chandler’s U.S. rates scenario comes true, the dollar would likely rise. Conversely, a U.S. rate cut may already be in the exchange rates, but some fall in the Dollar would still occur, and margin would increase that loss proportionately.

You can apply margin leverage to futures or spot FX positions as appropriate for your profile to increase the return effect (positive and negative) of your currency directional bets.

What do you believe about future US interest rates? How far? What direction? When?

An argument can be made that a portion of assets that might otherwise be in money market funds, should be held in a basket of currencies such as Euro, Yen and Dollars (the way China and other are arranging their reserve cash holdings). Foreign cash holdings earn interest too and create some overall exchange rate risk diversification.