- Euro enjoyed solid back-to-back weekly gains vs. the U.S. dollar on the heels of free-falling Treasury yields.
- EUR/USD jumped above its 50-week moving average for the first time in more than 90 weeks, which historically is a long-term bullish signal.
- Further short covering rallies are probable on elevated net short positioning by large speculators in euro futures.
- A long-term bull run is in the making for the euro based on technicals and further convergence in bond yields between U.S. and Europe.
Once thought to be immune against the global coronavirus outbreak, the U.S. dollar (UUP) strength came to an abrupt halt as the euro (FXE), Swiss franc (FXF) and yen (FXY) snapped back viciously against the USD off recent lows. Nosediving Treasury yields on bout of risk aversion and Fed's emergency rate cut certainly contributed to the beatdown in U.S. dollar, as the spread between 10-year Treasury and German Bund yields narrowed to 2016 levels:
Source: U.S. Department of Treasury, WingCapital Investments
Not even the much stronger than expected non-farms payroll number was able to stop the slide in U.S. dollar and bond yields, as 10-year Treasury closed solidly under 1% to end the week. Consequently, EUR/USD jumped for 2 straight weeks totaling 4% and above its 50-week moving average for the first time in more than 90 weeks:
Source: WingCapital Investments
The latter observation could prove to be a turning point for the euro, as there were only 3 other times in the past 3 decades when EUR/USD closed above its 50-week moving average for the first time after being under more than 70 consecutive weeks:
Source: WingCapital Investments
Empirically, we observe that during all of those instances, the euro was in the process of building a major bottom vs. the USD. While lows were tested multiples times during 2000 and 2016, a more sustained uptrend with 10+% gains ensued thereafter in both cases. Numerically, below shows the forward returns in EUR/USD in various time frames:
Previous Streak Under 50WMA
|Forward Chg||4-Weeks||12-Weeks||6 Months||1 Year||2 Years|
In the near-term, EUR/USD proceeded to make higher highs within the next 12 weeks in each of the 3 occasions albeit whipsawing action. More importantly, a 10+% gain would follow at some point over the next 1-2 years. Hence, although EUR/USD could remain choppy during the bottoming process, we will certainly look to buy on dips for the long haul.
More Short Covering Rallies To Be Expected
Another reason to expect more upside in the euro is the tailwind from short covering. With the euro having become the new carry trade in town, the subsequent unwinds could be fast and furious, as Deutsche Bank pointed out on FT:
"The euro is likely to exhibit increasing 'carry trade' behavior where depreciation is gradual but appreciation pressures sharp as positions are unwound," Mr. Saravelos said.
Indeed, the trimming of nearly 30k contracts in short euro futures last week certainly gave the euro an additional boost according to the Commitment of Traders report. With their net short positioning still elevated at 87k contracts, history suggests that the short squeeze has more room to go:
Source: WingCapital Investments, Commitment of Traders
Specifically, the above chart highlights the instances during which:
- Net short positioning dropped by more than 20% week-over-week
- Net short positioning remains above 50k contracts and increased over the past 3 months
The signal can be interpreted as the beginning of short covering cycle by large speculators after accumulating shorts over the past 3 months. Statistically, there is an 80% chance of further gains in the EUR/USD within the next 6-12 months after the trigger of the signal:
|Date||EUR/USD||Large Specs COT|| |
COT Week-over-week Chg
|Forward Chg||4-Weeks||12-Weeks||6 Months||1 Year|
As such, we anticipate euro to continue rallying until large specs' net positioning normalizes towards flat.
Bond Yield Convergence To Drive U.S. Dollar Lower
In light of the Fed entering a new rate cut cycle, the path of least resistance will be lower in Treasury yields. In fact, the fed fund futures are already pricing in another 90bps of additional easing by end of 2020 per Yahoo Finance.
Hence, U.S. Treasury yields are expected to further converge with Europe, where yields are already deep in negative territory and unlikely to head much lower. That would result in the USD losing its "single most important source of its over-valuation, a strong carry advantage" per Deutsche Bank.
In summary, both technicals and fundamentals suggest that a long-term uptrend is in the making for the euro vs. the U.S. dollar. Short-term consolidation is likely as depicted in the above analysis, and we reckon that will present a good dip-buying opportunity in the euro.
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