Go on, you know you want to

"Go on, you know you want to."

How many times over the last few years have macro punters contemplating a sale of the euro heard that voice inside their heads?  From the sovereign crisis to Cyprus, from Fed tapering to ECB QE,  there have been a myriad of (apparently very good) reasons to sell EUR/USD, and yet here we are, knocking on the door of 1.40.  Like the devil on Larry Kroger's shoulder, the voice looks at the chart and says it again.

"Go on, you know you want to."

It's a siren song that's hard to resist, particularly now that the ECB has joined the chorus.  In the absence of a ship-mast against which to lash themselves, punters would do well to examine some of the relevant narratives to determine whether it's a wise course to give in.

1) The 'Japanification' story.   A key argument against selling the euro has been the impressive rise in the Eurozone's basic balance over the last several years.    Not only has the emasculation of domestic demand in much of Europe pushed the current account into a tasty surplus, but Eurozone banks' unwinding of foreign assets has maintained a healthy capital inflow as well.  This combined demand for euros has gotta push it up, right?

The evidence is sketchy.   Macro Man can find no stable and sustained relationship between the basic balance and the euro.  That does not mean that there is no relationship, of course, merely that it does not appear to be a (let alone the) hegemonic driver of the euro exchange rate.  Indeed, at some points in recent history there appears to have been a negative correlation between the two.   The voice is getting louder....




2) Positioning.  With so many different actors participating in currency markets, it can be quit difficult to get a true read on accurate positioning.  Fortunately, the sector with the quickest trigger finger also happens to be the easiest to model positioning for, namely CTAs via the IMM data.  The story there is one of modest (and declining) length.   With the 50 and 100 day moving averages 50-120 pips lower from current spot, it wouldn't take much to trigger a flurry of stops, as that community exits longs and begins to go short.   The siren's song, it's so beautiful....



3) FX Reserve managers.  One of the earliest literary devices in this history of this space was the bequeathing of the sobriquet "Voldemort" upon the PBOC and SAFE.  The rationale was simple:  by accruing absurd levels of FX reserves to maintain artificially weak exchange rates (and artificially high current account surpluses), and then trading/investing these reserves aggressively, Voldemort and like-minded institutions were exerting a malevolent influence upon developed financial markets. Over the ensuing years, the influence of FX reserve managers has waxed and waned.  Recently, China appears to have been at least moderately active diversifying the $100 bio+ that they spent in Q1 to weaken the RMB.

However, how durable is this moving forwards?  The stated purpose of widening the RMB band and pushing the currency weaker was to discourage hot money speculation (both domestic and foreign.)   For the time being, at least, it certainly seems to have worked; moreover, it seems unlikely that the domestic corporate sector will play as many over-invoicing games as they have in the recent past.  At the same time, China's current account balance has shrunk back the level (as a % of GDP at least) of a dozen years ago, back when Voldemort was a mere Tom Riddle...


It therefore seems likely that reserve accumulation should slow, perhaps dramatically...and with less reserve accumulation comes less diversification demand for euros.   Hmmm, Macro Man is reaching for his red sell tickets....

4)   Interest rates.  Rate differentials are the bread and butter of any study of exchange rate determination.  Applying them to EUR/USD appears to support the conclusions above.   Based on the historical relationship with the 1y1y spread, for example, it looks like the euro should be closer to 1.20 than 1.40.   It's an open and shut case, right?




Not so fast.  Readers may recall that there were other interest rates than 1y1y swap spreads (themselves a proxy for monetary policy) that were driving the euro exchange rate in 2011 and 2012.   A proper rate model should include some sovereign spread component.   Macro Man ran two iterations of a very simple two factor model, using a measure of short term rate differentials and the 5 year Spain/Germany spread as the input factors.  One uses 2010-11 as the in-sample period (the Trichet model), and the other uses 2011-2014 as the in-sample period (the Draghi model.)


The Trichet model is not dissimilar to something that Macro Man ran in real time in 2011.   What's interesting to note is that the model broke lower relative to the actual market starting in July 2011- almost exactly the time that Italy and Spain got properly sucked into the sovereign crisis.  While the model has consistently suggested that the euro is too high since, it has retained a reasonable degree of correlation with movements in the FX rate, even in the out of sample period.   What is very interesting to note is the seemingly inexorable rise in the model since Draghi's "whatever it takes" speech in the summer of 2012.  How does it look if we use Draghi as the in-sample?

 

Pretty darned good.  Encouragingly, the basic shape of the model barely changes from the earlier version with a completely different in-sample data set. This version merely corrects for the structural break that occurred in July 2011.  The message, as you can see, is that the euro is pretty fairly valued, and that the recent rise is completely justified. 

Now, one can quibble about using a model like this to try to pin-the-tail on an exact currency valuation.  Indeed, Macro Man received a first-hand education on the dangers of such a practice three summers ago.  Nevertheless, to his eye at least these models do a pretty darned good job in explaining the underlying direction of the euro's trend.  And they both agree that it is up.

As such, from his perspective selling euros, while potentially profitable around event risks like ECB meetings, does not carry a terribly large (or even positive) expected value on a more strategic basis.  From his perch, therefore, it appears that punters' time could be more profitably spent finding a better trade.

Go on, you know you want to.
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Anonymous
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April 17, 2014 at 7:23 AM ×

How 'bout purchase price parities, sir ? Is this anything you look at or do you think it is too long-term/highfalutin/french to be of any use ?

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Anonymous
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April 17, 2014 at 9:08 AM ×

Great post.

Is there any case that money into EU equities is helping eurusd bid to some extent? Just a thought.

Personally think the last ECB statement / q&a is a pretty big deal - even the Buba is on side and the last 2 guys there jumped ship given they were against the ECB measures. Even without the action still think this commentary is a big swing in policy we couldnt have dreamed of not so long ago. Meanwhile the EU periph (even with everyone applauding spain/port austerity) has no way of stabilising d/gdp ratios without i) rapid economic growth (eg 3/4%) ii) inflation... Both require a weaker euro...

p.s have been thinking same thing for 6 months mind so probably best to ignore me...

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CV
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April 17, 2014 at 9:38 AM ×

Great post MM, I think that the current account is more important than investors believe. Try plotting the relative current account vis-a-vis the US and the EURUSD and a nice picture emerges. Also, this would fit with FX markets' general over-obsession with CA surplus v CA deficit economies in the past 12 months.

- Yields in the periphery are low and falling.

- Real money growth is still strong.

- Capital outflows have halted

- Growth has improved

Where is the fire? Deflation in the periphery? Well that is the price you pay to stay in the doomsday machine. The ECB is being bullied by the market to act, but this is not a one-way street. The last thing they want is to rekindle animal spirits in the periphery and see the current accounts there tip back into negative (i.e. this would mean back to higher yields and funding issues). As I said, a doomsday machine where low growth is good and high growth is dangerous, debt goes up and up but in the end it all sits in the domestic banking system.

So low growth, low inflation and Japanafication as far as the eye can see.

Claus

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Anonymous
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April 17, 2014 at 9:46 AM ×

C says
Watson has thrown his copy of Currency for Dummies on to the fire in disgust. Look Holmes we had a commanding officer like Draghi in Maiwand. Waved his bloody baton and said 'up and at them chaps. We'll shell them and soften them up for you'. Never bloody told us there were no shells left. Just got us to do what he wanted done with a few choice words and nevermind the casualties (rubbing his shoulder vigorously). That book was rubbish ,it had no chapter on what they say is not what they do.
I'll just have a tenner on Betty running in the 2014 Scottish race.

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Anonymous
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April 17, 2014 at 9:50 AM ×

C says
Good calls Claus. I think there is merit in thinking that market thinks in sprints whilst the EU bureaucracy thinks about marathons.

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Anonymous
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April 17, 2014 at 2:24 PM ×

Great post, thank you. Regarding the two model analysis, while brilliant, isn't it describing the same factors at work in terms of capital account, inflows, etc. as it relates to the peripheral spreads vs Germany (in other words the comparison is second order in a way, that you are comparing something already correlated)? Second the 1y1y is exactly what please? the 1y1y spread of USD and EUR or the the 1y1y swap spread of each respectively please? Lastly, and thank you again for such a great posting as this subject has become a primary item (after USD rates maintain a range and Yellen & Co. try to put out the reverse forward guidance fires and attendant boredom), with the ECB now increasingly focused on it, my question keeps coming back to 'why'? This you have attempted to deal with, which is great. However I keep coming back to wondering whether the strength isn't exogenous as it relates to the 3 legged stool that is international capital flows and debt between China, US and EU as described some years ago by David Folkerts- Landau and his work on international monetary systems some years ago -http://en.wikipedia.org/wiki/International_monetary_systems

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Macro Man
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April 17, 2014 at 2:38 PM ×

@ Anon, yes, there is a correlation between the two model factors (.39 from 2010-2014); however, the t-stats and p-values of both factors in both sample periods are very highly statistically significant. Obviously a rate differential model is attempting to capture capital flows; the two factors chosen attempt to capture this via a monetary policy term (ie very short term rate differentials) and a credit term (the peripheral spread.)

The 1y1y spread referred to (which is not the factor used in the model, btw) simply refers to the difference between 1y1y swap rates between the Eurozone and US.

While I certainly don't discount China's influence (long time readers would NEVER accuse me of that!), the point of this exercise was to drill down to the simplest explanation for the 'baffling' strength of the euro. Common sense, perhaps, but I often find it useful to take a step back and shave with Occam's razor.

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Anonymous
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April 17, 2014 at 2:53 PM ×

Thank you for the explanation, that makes a great deal of sense. Sometimes the only way to understand a situation like this is to take a large step back. I can't shake the feeling to sell the euro though and begin to wonder whether we have a squeeze on hand and the counter intuitive move is right, as your analysis would also suggest, and we see 1.45 or more before this is done. Isn't interesting that with credit growth so weak in Europe, peripherals should be so strong? I am beginning to think that Draghi et Cie's bluff will be called and the Euro ignore the QEasy calls forcing them into a corner and eventually act with the same finality and error as Trichet's fatally misguided rate hike.

One last question please; how and what does the significant adjustment in Greek cds rates as compared to bond yields (from your earlier post) equate? With cds values higher and yields lower relatively, what does that say about the efficacy of what price levels relate to investment expectations and default? Ed.

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Anonymous
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April 17, 2014 at 2:55 PM ×

Clarifying that last question - greek CDS values are higher and yields lower ceterus paribus.

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Macro Man
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April 17, 2014 at 3:15 PM ×

Well, I do wonder about the accuracy of the CDS signalling mechanism these days. I am far from an expert on that market, but it seems to me that their use has really been curtailed due to regulatory and market pressures over the last few years.

As for the level of Greek paper....well, call me crazy, but I think I'd prefer 5 year Mexico to 5 year Greece at comparable yield levels.

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Eddie
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April 17, 2014 at 5:47 PM ×

Re Greek CDS: a new protocal(extending the existing protocol) is announced and will go live this year. The new protocol covers among other things forced restructurings and similar things, basically all the issues we encountered during the major f... up.... aahh.... Great Financial Crisis.

Thus the current "old" CDS contract might look a bit whacky since these things are not factored in properly.

HTH.

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abee crombie
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April 17, 2014 at 10:20 PM ×

Nice post MM, how are you making your simple models, multi variant regression or some kind of machine learning?

I can find better casinos to lose my money instead of the EURUSD, but I would think the crosses would trade better, GBP in particular.

But the recent jawboning by ECB officials will probably lead to something, how the EURO trades afterwards will be interesting. Figuring out what will benefit the most from that will probably be a better trade

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Anonymous
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April 18, 2014 at 12:40 AM ×

Euro and Yen short: respectively the two most overhyped, macro "themes" ever.

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Anonymous
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April 18, 2014 at 9:56 AM ×

What's the right ticker for USD 1y1y swap rate in bbg, please? many thanks! great post!

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Anonymous
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April 20, 2014 at 6:31 PM ×

regarding positioning, is it really the case that the most volatile and squeezy participants are net long?

If you look at spread betters/CFD traders you have had numbers north of 90% short for some weeks...

Is this not as relevant as a sentiment gauge?

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Blake Yerian
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April 26, 2014 at 11:04 AM ×

Interesting read. As a long term half-of-every-paycheck-deposit carry trade investor, I still like shorting the Euro against high interest currencies. Using 8x leverage for a 15-20% return is pretty safe when it comes to longterm volatility, and leaves years for the Euro to find its way downward.

PS- Not sure how long that capital will flow into Europe; it seems more of a temporary safe haven during stimulus season to me.

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