Fighting The ECB - It's Time To Buy The Euro

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Includes: EUO, FXE, HEDJ, ULE, VGK
by: Seethrough Macro

Summary

The cyclical outlook in Europe is the best it has been in a long time.

Short Euro is a crowded trade.

The Euro has fallen significantly and is now slightly undervalued.

The coming "Euroboom" may trigger a turnaround.

Short Euro has been a profitable and widely recognised trade over the past year, but with extremely easy financial conditions and an approaching "Euroboom" upturn in economic growth, the Euro is no longer a one-way bet.

1. Extremely easy financial conditions: With the aggressive ECB easing program (rate cuts, credit easing, asset purchases), and fall in the real trade weighted Euro, financial conditions in Europe have become extremely supportive. In fact the present combination of financial conditions are the most easy they have been on record; this will provide a powerful tailwind to growth in the near term.

Source: @Eurofaultlines

Unsurprisingly then perhaps, leading indicators such as real money growth are pointing to booming levels of growth (e.g. chart below points to a PMI well above 55). This would mark a notable turnaround in prospects from recent years, and would call into question the notion that Europe is heading for a deflation trap.

2. Short Euro is a crowded trade: Perhaps the most compelling argument that the Euro could perform in the short-term is the significant speculative short positioning on the Euro. If the economy starts to improve as indicated above, and we start seeing stabilization in inflation numbers, there is the possibility for a rapid unwinding of positions - a classical short-squeeze (as happened in the later part of 2012).

3. Grexit risk is overrated: one common reason cited for the degree of bearishness on the Euro is the "Grexit" risk premium. But although headlines would have you believe this is a pressing and probable risk, it turns out Greeks actually like being in the Euro (about 70% are in favor of the Euro). There is also strong political will to keep Greece in, and there has been some promising comments by key people around the possibility for a deal. If you want a catalyst for a rally in the Euro this is probably it.

4. The US Federal Reserve is on the go-slow: on the other side of the equation, the US dollar has found significant strength, partly based on the premise that the US Federal Reserve is about to hike rates. Given poor data in Q1, and still considerable slack in the labor market, the Fed is likely to move later and slower. A slower moving Fed means the recent US dollar strength could be done. Indeed, for the US dollar to keep rallying, you would probably need to see signs of a sooner and more rapid rate hike cycle (no signs yet, but something to monitor).

Summary: When you line up extremely supportive financial conditions and what it means for the growth and inflation outlook in Europe, with crowded short positions, and a slower moving Fed, the case for short-term strength in the Euro is there. Particularly as the EURUSD is now below its PPP valuation (estimates around 1.25). At the same time, the Grexit risk premium is likely holding the Euro back, but this risk is overrated and if some sort of deal can be agreed this would be a catalyst for a sharper short-term rally. As such the Euro should see support in the next 3-6 months, so investors should factor this into their Euro currency positioning.

Apart from adjusting the hedging of European equity exposure (for example switching from the hedged ETF: WisdomTree Europe Hedged Equity ETF (NYSEARCA:HEDJ) to the unhedged ETF: Vanguard FTSE Europe ETF (NYSEARCA:VGK)), a direct way to take a view is via the CurrencyShares Euro ETF (NYSEARCA:FXE). This ETF provides simple exposure to the EURUSD exchange rate. At present the largest and most liquid Euro ETF is the leveraged short ProShares UltraShort Euro (NYSEARCA:EUO) - but as you might guess, we would take a bearish view on that one. The largest leveraged long Euro ETF ProShares Ultra Euro (NYSEARCA:ULE) is actually quite small (only $14.5M in NAV) so a better way to play leveraged long Euro would be via options on FXE - which has a reasonably active options market (or through other forex instruments).

Risks: There are a few risks to the view, Grexit remains a source of downside risk and further noise could keep the Euro capped. Also if the US economy starts to accelerate it could start to change the view on the timing and pace of Fed rate hikes. There is also the headwind of ECB QE - which is generally understood to be bearish for the Euro (likewise negative yields should encourage shorting of the Euro as a funding currency for carry trades). So it would be worth monitoring these risks.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.