The euro has rallied the past few days over relief that the Greek problem is exiting the headlines, for now. Buying momentum appears strong, with the currency rising 1% over the past 24 hours. However, I expect that this move will be short-lived, and that the medium-term downtrend will resume.
There are three potential catalysts for the resumption of the downtrend. First, although the market's initial reaction to the Greek denouement has been positive, there is little cause for celebration. Since the euro is effectively a currency basket of the 17 countries of the Eurozone, the fact that Greece is remaining means that a weak-currency member is staying in, diluting the euro's value. Though Greece represents only about 2% of the Eurozone, the spectre of a future mess should weigh on the euro, and more messes there are sure to be.
Second, the interest rate differential between US and German 5-year bonds has been shifting in favor of the dollar, moving more than 10bp in that direction over the past three days. A 5-year US treasury now yields about 2bp more than a comparable German bond, up more than 10bp in just ten days. Since the beginning of the year US 5-year bonds have had that 2bp advantage over 5-year bunds on three separate occasions, and each time the euro was trading in the 1.29-1.30 zone.
The third force working against the euro is LTRO, the European version of QE. (A comparison of LTRO to QE can be found here; visual evidence of the similarities is available here.) This ECB equivalent of QE is being executed in two tranches, the first on December 21 of last year, with the second due next week, on February 29. The size of the first tranche was EUR 489 billion, though more than half of that amount consisted of "rollover" loans. The second tranche is unlimited in size--it's up to the banks--with President Draghi stating at the last ECB meeting that the second tranche would probably be about the same size as the first. I suspect he's lowballing.
(Data source for all charts: Bloomberg)
Above is a chart of the euro during the the second QE operation of the Federal Reserve, a $600 billion intervention that effectively began with a speech by Chairman Bernanke on August 27, 2010. The procedure ended on June 30 of the following year, and as we see above, the dollar lost considerable ground, giving up 14% over that 10-month period. Because LTRO is so similar to QE in its scope and goals, it would be surprising if we did not see pressure on the euro.
It is curious that we have not already seen some sort of impact from the first tranche of LTRO on the currency. In fact, the euro is about 1% than it was on the day the size of the first LTRO tranche was announced. Some have explained the phenomenon by pointing out that overnight balances with the ECB rose by about the same amount as the LTRO operation.
In other words, all borrowed funds ended up right back at the ECB. Indeed, that is the case, but a similar rise occurred at the Fed during QE II, and the dollar weakened anyway. We should keep in mind that the circumstances of the US and European operations are materially different and may not play out in the same manner over the same period of time.
What the euro does not seem to be doing is blindly cuing off of other markets, which has often been the case over recent years. During the last run-up in the price of crude oil over the 2009-2010 period, for example, the 90-day correlation between crude and the euro reached as high as 93% and was above 80% for much of 2009 and 2010. As we can see above, however, more recently the correlation has been negative. The automatic pairing of the two has clearly dissipated.
The same can be said for the dance between the euro and the S&P 500. Although the correlation of the pair exceeded 90% for portions of 2009 and 2010, at the moment the 90-day correlation is negative, as we see above. We may now be witnessing a recoupling of the two assets, but that relationship is hardly a given, as it was following the stock market low of March 2009.
We therefore have a number of negatives that can weigh on the euro over the medium term, notwithstanding the ever-changing political landscape in Europe. As we just saw in the correlation studies, it is not necessarily the case that the euro is simply following the oil and stock markets higher as it has done over the past few years. Still, there is considerable momentum behind the move of the past few trading sessions, so I prefer to scale into this strategy by initiating a small short (as I have done), and to add to the trade if the euro rises to 1.355. If the euro moves beyond that to 1.375, I plan to exit the trade and seek opportunities elsewhere.
Disclosure: I am short the euro and plan to add to the position.
