The EUR/USD Is a Coiled Spring

by: Douglas Borthwick

While the EUR/USD trades with a heavy tone, the fundamentals continue to argue for it to trade much higher. The market is concentrating on this week's EU meetings, while a number of factors move in the EUR/USD's favor.

The 2-year swap differential between the U.S. and Europe is now at 160 bps, last seen when the EUR/USD was trading between 1.4500 and 1.5000. European policy makers are talking with a hawkish tone while the U.S. Federal Reserve remains handcuffed to a dovish view by anemic employment and continued terrible housing data. The ECB's Stark said it best last week when he noted the market mistakenly focuses on the poorly performing 5% of Europe, while ignoring the stronger 95%.

This is something we have argued for some time. Ninety five percent of the moves in the EUR/USD are triggered by news from the 5%. There have been a number of instances where moves in the most illiquid market (CDS in peripherals) results in moves in the most liquid markets (currency).

Yesterday my colleague, Dan Dorrow, wrote a paper detailing the differences between Greece and other nations that have soldiered through crisis, he said the following:

"Strategy Update – Greece Without a Central Bank of its Own

Regardless of one's view on the advisability of the euro-zone project, the fact is that Greece is now stuck without a central bank and currency of its own to facilitate economic recovery and ease its debt burden. Much attention has been paid to this negative, yet Greece reaps important – and underappreciated – benefits from its status as ward of the ECB and the greater euro-zone governments. This advantage distinguishes the current Greek (or insert "Irish" or "Portuguese") sovereign debt crisis from past EM crises that have produced market-forced, disruptive outcomes.

EM Sovereign Debt Crises

In a typical EM crisis, the government's inability to refinance maturing debt leads (in the early, pre-default stages) to a cash payout from government balances held at the central bank. Thus, the money supply increases without a commensurate increase in money demand because the former bondholders (whether foreigners or a local) lack confidence in every aspect of sovereign risk exposure. Their desire to exit local currency exposure results in the purchase of FX, with the central bank the only seller in the market. Consequently, the drop in demand for government debt is mirrored by a commensurate loss of central bank FX reserves. Since FX reserves are a finite resource, at some point the unsustainability becomes obvious and the central bank turns off the spigot, forcing an abrupt regime change.

Simultaneously, commercial bank liabilities shrink as depositors exit due to sovereign risk/FX concerns and as banks pay down other funding sources when they decide not to roll over their own holdings of maturing government debt. Both reasons for bank liability reduction lead to FX demand; often banks' funding is in other currencies based on open-FX-position carry trade considerations. Thus, the sovereign crisis becomes a shrinking banking sector crisis, with potentially severe real economy implications.

In short, once a sovereign crisis develops, a central bank with too-few FX reserves results in an endgame by which a rush for the door leads to both a devaluation and a messy default.

The Greek Sovereign Debt Crisis

Greece, comprising only 2.1 percent of euro-zone GDP, is small enough to make a fiscal rescue possible. Only a few more tenths of a percent of euro-zone GDP is required to completely fund Greek financing needs until end-2013. But critically, in the event that a fiscally-based solution for Greek funding fails to arrive for an extended period of time, Greece's situation within the euro-zone allows it in the meantime to borrow credibility from the greater regional whole.

First, the cash/monetary payout of Greek debt, whether from ECB market purchases or amortizations (that are refinanced using EFSF funds) are not permitted to create an undesired, EUR/USD-pressuring monetary expansion. The ECB is well able to sterilize the potential monetary impact of its own accumulation of peripheral bonds and also control base money effects from governments' cash payments/receipts. The ECB is one of the pillars of global central bank credibility, the guardian of a trusted central bank reserve currency. The ECB rate hiking cycle, underpinned by robust euro-zone Q1 GDP growth, is the complete opposite of EM crises in which growth is negative, pressuring for looser policy.

Second, falling confidence in Greek banks, a result of their holding of Greek government debt, is redirecting some deposits to other euro-zone banks – but critically, not away from EUR exposure. Confidence in euro-zone banks is strong; the EUR/USD basis swap is near a post-Lehman-crisis low (in absolute value -- Chart 1). Again, lack of monetary/currency independence means that Greece will not be pushed into a corner by an FX-reserve-constrained central bank defending against a maxi-depreciation of its currency.

So long as Greece muddles through with roll over assistance from the EU/IMF, the absence of a monetary/FX component to its debt crisis means that there is sufficient time – room for negotiation – to achieve a true solution to its fiscal problems. Greece is not an emerging market. To the contrary, it's a state imbedded in one of the most developed markets anywhere, with more than adequate institutional strength and fiscal resources."

Dan's points are valid. The EU, the IMF and the ECB will all allow Greece the necessary time to "muddle through."

Over the next few weeks we will gain more color regarding Greece. Whatever the outcome, we expect the surety of a solution to be EUR/USD positive. The EUR/USD has pulled back over the past few weeks from its highs as the market has unwound positions given the uncertainty. Certainty will attract long EUR/USD positions.

Central Bank activity continues to dampen USD strength in general. With Asian Central Banks and Middle East reserve managers continuing to buy the EUR/USD, GBP/USD and AUD/USD on dips.

We believe that just as the move from 1.4920 to 1.4050 was fast; the move from 1.4150 back to 1.5000 will be just as swift on the back of rising interest rate differentials, greater certainty and market positioning. The market is no longer extremely short the USD. Indeed our most recent poll suggests that shorter-term macro funds are now long the USD and short EUR. Bank desks are currently short the EUR/USD as well. We expect both positions will be squeezed out and liquidated as soon as clarity in the problems faced by the European 5% rises.

We held a 3% trailing stop in our short DXY (USD/Index) position from Dec 3rd, 2010 that was executed last week, locking in a gain of 5.66%. Once again we like shorting the DXY (USD/Index) with the usual 3% trailing stop. Clarity is coming to the coiled spring.

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