Sense checking the EUR/USD trade

Hi ho silver!   Well, not really; after a nice break higher in the US morning, price action was actually pretty flaccid.  So despite silver finally breaking its record losing streak, it felt notable that commodities seemed to lag the dollar weakness that materialized in FX markets.  Even there, the strength of the euro has actually been quite modest; however, given the increase in positioning and the lack of evident catalyst, the correction somehow felt a bit bigger than it actually was.

Given that increasing focus is being paid to positioning risks on the dollar trade, particularly versus the euro, Macro Man thought it was worth re-visiting the trade through the prism of a number of fundamental factors that typically drive exchange rates.  None of these will provide much real-time comfort if and as a positioning squeeze materializes, but recalling where we are in the bigger picture can provide an intellectual anchor to knowing how to trade the noise.

Let's look at 5 factors that impact the supply and demand for currency over time:

* Short rates
* Long rates
* Other monetary policy considerations
* Valuation
* External balances

Obviously there are other factors that come into play, such as central bank diversification flow and international equity investment; at the moment, however, the former is reacting to developments in the first 3 factors while the latter is generally not large enough to make a substantial impact.

Short rates

Developments here are pretty unambiguously negative for EUR/USD; since the "policy divergence" theme came to the fore a few weeks ago, EUR/USD has followed the evolution of the 3 month forward points more or less to a T.

Putting the FX forwards into historical context, we can arrive at a couple of different signals.   The current level of the 3m forwards (in red in the chart below), while the highest since the crisis, are nevertheless pretty paltry in the grand historical context.  This would argue for a relatively meager bear signal for EUR/USD that one could argue is more than in the price.   However, the level of the implied interest rate differential (0.90% in the 3 month tenor) is massive considering the low (or in the case of Europe, negative) level of interest rates.   Indeed, if we express that implied rate differential as a percentage of the US interest rate, we find that this is the largest difference in the history of the euro!  This would certainly argue in favor of further weakness in EUR/USD if that implied differential remains steady or widens further.

Long rates

The Treasury/Bund spread is widening back out towards the multi-decade highs of the spring.  One could argue that until it gets there, the justification for further euro weakness may be weak.  Moreover, the historical link between this spread and the exchange rate is poor on a contemporaneous basis.   On the other hand, these are the sort of market developments that impact central bank asset allocation decisions (as well as spreads at the short end of the curve.)  Indeed, there has been plenty of anecdotal evidence of reserve managers shifting out of European government securities because of the low yield on offer.  For your guide, they're not sticking that money on deposit to earn zero; they're getting the hell out of dodge.

In reality, it may be unrealistic to expect to much more of a widening from here, given how stretched we are from an historical perspective; barring an abrupt narrowing, however, the yield advantage of Treasuries across the curve should keep attracting central bank flows.

Other monetary policy considerations.

In other words, QE.   The ECB is expanding its balance sheet and looks set to accelerate and/or extend that trend in a few weeks' time.   The Fed, meanwhile, has been there and done that; while they haven't got the cojones to shrink the balance sheet just yet, even through ending the portfolio reinvestment policy, the tide of relative balance sheet expansion has tilted unquestionably against the euro.   This factor has borne a solid resemblance to the trend in the EUR/USD exchange rate after the crisis, and looks set to point towards more euro weakness.

Valuation

Macro Man is old school (quite literally); he uses a PPP model that he first developed a dozen years ago to generate his estimate for EUR/USD fair value.   This is not a dynamic model, and there is little expectation that deviations can or should be corrected quickly.   His current PPP estimate is 1.17, with European deflation pushing it higher since its 1.08 valuation before the crisis.

It's interesting to note that the model shows the euro to be undervalued for the first time in a dozen years; coincidentally (or not), that was the last time that FX reserve managers didn't feature heavily as regular buyers of the single currency.  The current misalignment is exceptionally modest by historical standards; it's worth observing that most cycles have taken the euro to be misvalued by at least 20%.  As such, valuation is not much of a concern...yet.   Below parity, on the other hand, and the magnitude of undervaluation will be sufficiently large as to prompt greater inquiry as to how and when the rubber band might snap back.

External balances

Here's the thing about current account balances: they don't matter until they matter.   In the ordinary course of business of open financial systems, capital account flows tend to dominate supply and demand demand for currencies.  Ordinarily, countries running C/A deficits compensate investors for financing the deficit; investors generally like to be compensated, and so the C/A gets financed.   Obviously, you occasionally find situations like Brazil over the last couple of years, where the compensation is deemed inadequate for the financial/political/economic risks, and then current accounts matter very much indeed.

As such, they are worth observing, not as a signal for what will happen today, tomorrow, or this time next year, but rather as a signal for what will happen if everything resets to zero.   In the case of EUR/USD, you will probably not be surprised to see that the current account factor is not at all supportive of the dollar; indeed, over the last year the relative current account and the EUR/US exchange rate have moved in opposite directions.

 Now, given everything written above, it would be absurd to buy euros based on this current account dynamic.   There is almost always a narrative that accompanies periods where current accounts are useful as factor of exchange rate determination; you know, G7/G20 statements, that sort of thing.  We're clearly pretty far away from that at the moment.  Nevertheless, it is worth noting that if the compensation offered by the US to fund its C/A were deemed insufficient (such as negative interest rates, god forbid), then external balances would likely matter again, and the US would look very ropy indeed.

How are we left?  The short term fundamental drivers of the EUR/USD exchange rate continue to point towards further weakness.  Longer term risk factors both argue that the EUR should be stronger; frankly, over a full market cycle (if such a thing even exists any more), it almost certainly will be.  Macro Man is left much wear he started; thinking that we'll dip below parity, and that the ex ante returns from the trade won't look so good once we do.  In the meantime, any slings and arrows thrown his way from positioning unwinds are best viewed as an opportunity rather than a threat.