We have spent the better part of the past 18 months discussing with the macro community why the EUR/USD would not follow the European CDS due to the inordinate amount of EUR/USD buying by Asian Central Banks and reserve managers that has been largely unreported in the public realm.
While the EURO has fallen against the crosses, it has stayed relatively well bid against the USD. From our first note at 1.2200, the EUR/USD rose first to 1.3680, pulled back to 1.2860 and then rose to 1.4940. When it then tested the downside at 1.3838 on July 12th and rallied, we called for 1.5000 before seeing 1.3900 again. While the EUR/USD rallied to 1.4580 it quickly sold off last week below our 1.3900 level. This time we are unable to support it unless action is seen from the international community.
This past week has seen a sea of change from the reserve manager community. In part due to moves at the ECB, as Stark resigned on Friday, but also on growing fatigue over European dithering. While it is easy to argue why Germany and France would want to be part of the EURO given their growth in exports off the EUR/USD's drop on peripheral weakness from September 2008's 1.6000 area, and while it is easy to argue why Greece, Ireland and Portugal would want to be a part of the EURO given their access to funding markets and cheaper interest rates from the richer members, we have no argument for why Finland would want to remain.
Reserve managers have been looking for swifter policy changes out of Europe; unfortunately, given the way that the Maastricht Treaty was written, speed is not an option. This does not mean that reserve managers have and will stop buying EUR/USD as they switch from USD reserves into European reserves. But it does mean their resolve has dropped considerably. Unless the IMF or the US finds a way to take the leadership reins from the European Union, we see bleak days ahead for the EUR/USD. A lower pace of EUR/USD purchases will provide less of a buffer against EUR/USD selling from the macro and CTA community.
Reserve managers will continue to move reserves out of the USD and into Europe, but it will be at a slower pace. They have to continue doing so because in the end they have to answer to their populace, and 65-75% in the USD is not 'prudent' policy, and the purchase of EUR/USD is 'prudent' in that it takes profit on USD longs/EUR shorts from the days before Lehman's demise. Also remember, the reserve manager time horizon is longer than the macro manager who is forced these days to look at returns quarter by quarter and even month by month. Reserve managers will continue to buy, but they will be in no rush.
They will stop buying EUR/USD if there is a significant event in Europe. That could include Greece defaulting, a country leaving the Euro, or even a run on the larger banks. Remember, it is rumored that French banks will be downgraded on Monday morning. Such an event could cause the PBOC to announce a re-peg to the USD, which in turn would cause a significant rally in the DXY (USD/Index). We believe such an event is closer than the market expects.
As demand for the EUR/USD is diminished, pressure should move to the EUR/Crosses, notably EUR/SEK, EUR/NOK, EUR/JPY and also EUR/CHF. Unless the US or the IMF can run to Europe's rescue, we believe that the action by the SNB in drawing a line in the sand at 1.2000 could prove to be a very expensive exercise for the Swiss Cantons. They obviously looked at the cost/benefit of intervening versus writing checks to their exporters, however, we believe their conviction will be tested this week as pressure on the EUR/USD drives flows to neighbors shores.
As to where we stand on the EUR/USD today. We are neutral to negative as of this writing given we may see further statements from the G7 on possible plans for the eurozone. After all, the next move in the EUR/USD will either be from 1.3000 to parity when it is obvious nothing is forthcoming; or else it could be from 1.3500 to 1.5000 should a multilateral plan come into play.
A multilateral plan could come in many guises including a global easing effort from the West, with the US, the UK and Japan announcing further massive Quantitative Easing as the ECB announces an emergency cut in interest rates. Or from the East, with Chinese buying of European core debt, though to be clear, we have no wind of this. Interestingly, the IMF is rumored to be re-activating a $580 billion resource pool, called 'New Arrangements to Borrow' from which around $330 billion is currently available. This would swell the current resources available for bailouts from $60 billion to $390 billion. If a multilateral plan is in the works, reserve managers would love to hear of it. Unfortunately for Europe, at the moment, words are speaking louder than action.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.