I have been bullish the EUR/USD and negative the DXY (USD/Index) since June 21st, 2010. The primary reason behind this view was the causality of USD/CNY on the USD/Index. When China is in a 'flexible' mode, USD/CNY drops and the USD/Index drops with it. This is because Chinese 'flexibility' results in the Chinese buying less USD in the market and upping their purchases of the SDR currencies comprising EUR, GBP and JPY along with commodities.
Our bias to be long the USD/Index led us to see the EUR/USD rally from1.2200 to a high of 1.4940 on May 4th, 2011. We have spent the rest of 2011 with either a long EUR/USD bias, or a neutral bias. Most recently we called for a long bias at 1.3560 in the EUR/USD on positioning and saw it rally to 1.4250. Our bias remained long at the 1.3300 area over the past 70 days as we understood there was Asian Central Bank support below, and fully expected the IMF to announce a separate 'Trust' for European National and other Central Banks to contribute monies into. The IMF would use this 'Trust' as the lender of last resort. Providing a secondary funding option to European countries should market yields prove prohibitive. Yesterday at 1.4200 in the EUR/USD we got news that the Bundesbank was only willing to offer bilateral loans to the IMF's general fund. Given this would co-mingle new funds with US interests and US Congressional oversight we immediately changed our view on the EUR/USD from positive to negative. The pillar for my analysis on EUR/USD short-term strength had been knocked down. The longer term view though remained. That China would continue on a path of 'flexibility.'
The view that China would remain on a path of 'flexibility' was dashed last night following comments at the Chinese annual Economic Work Conference, reported by Xinhua news. There it was remarked that China would maintain the Yuan exchange rate basically stable. 'Basically stable' is not 'flexible.' The second pillar to our analysis was removed.
With neither the IMF able to take a role as lender of last resort, nor China and other Central Banks selling the USD in the market I see this as extremely EUR/USD negative and positive for the DXY (USD/Index). We have re-entered a market similar to that following the demise of Lehman Brothers, where the Chinese re-pegging back to the US Dollar resulted in a significant move higher in the DXY, considerable weakening of emerging markets currencies, commodities and equity indices.
In 2008 the US Federal Reserve was able to create a cushion to stem USD strength and bring back market confidence. That market confidence is now dwindling. If the ECB was to provide the same comfort to Europe through QE it would not be EUR/USD positive, rather it would weaken the EUR/USD further. I now expect that we will see increased pressure on the ECB to quantitative ease, however they will likely be stubborn until the treaty revisions envisionned in March 2012. Should market tensions exacerbate before then I fully expect the US Federal Reserve will announce QE3 as a stop/gap measure.
The IMF's Lagarde noted last Friday it would take her 10 days to finalize the IMF's role in the European bail-out. This remains a short-term risk to my view of EUR/USD weakness. Should she announce the formation of a separate 'Trust' that the Bundesbank and other Central Banks can contribute to, then the EUR/USD may have the ability to stabilize, something that could change China's mind, and allow them to continue on the path of 'flexibilty'. For the moment though, based off Bundesbank and Chinese comments, it seems this option is off the table. With no pillars of support the EUR/USD is likely to weaken considerably, bringing commodities and equities with it.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.