Time for caution on the euro

If you believe that markets turn not with a bang but a whimper, then yesterday should have you salivating with contrarian opportunity.   Tuesday's brutal ISM report sent barely a ripple through markets, let alone an earthquake, even though it was another tasty miss in a key sentiment indicator.   Although manufacturing represents only a small portion of the US economy, it does tend to punch above its weight in terms of sentiment.  It's interesting to note, therefore, that the Fed has not hiked with ISM below 50 since August of 1985...and even then they were cutting by the end of the year.

Although Macro Man was not particularly surprised to see equities rally, because the cheerleaders in Santa suits are out in full effect, he was actually taken aback by the relatively modest uptick in the euro.   Positioning is clearly there, and nervous ahead of the ECB, payrolls, and Fed...how else to explain the recent surge in the skew in short-dated risk reversals towards calls?

It's hard to know if yesterday's modest pullback represents a market that feels well-hedged or merely has its head stuck in the sand.  We've already seen some positive divergence in the euro, with new lows in price being accompanied by (marginally) higher lows in momentum.   This is usually indicative of late-trend price action that is vulnerable to reversal, and with so many potential event risks it's not hard to see where a catalyst for such a reversal might come from.

Take Thursday's ECB.  It has been foolhardy in the extreme to fade Draghi since his ascension to the ECB presidency in 2012, but given the extent of the decline in the euro recently it kind of feels like most reasonable outcomes are already in the price.   Indeed, if recent press reports are to be believed, there has been quite a bit of internal pushback against some of the more aggressive schemes that have made it into the public domain.  For choice, Macro Man would suggest that a 10 bp depo rate cut, a modest (10 bio?) increase in monthly purchases, and a 1 year increase in the duration of the QE program are all in the price of EUR/USD.

Could Draghi deliver more?  Of course...though it's hard to see the ECB moving out the credit curve, and some of the mechanics of substantially increasing government purchases will be a bit tricky.  Yes, they could potentially do more on the depo rate, but how much good will that actually do if some of the punitive charge is passed on to depositors?  Moreover, it remains entirely possible that the ECB does less than currently expected if the internal opposition to further easing is fairly staunch.

Returning to the US, meanwhile, while one ISM number likely won't sway the Fed it's worth taking a step back and taking stock of some trends in the economic data.  If it seems to you that the US data has been disappointing for quite some time, well, you'd be right.  In fact, the Bloomberg economic surprise index has been negative every day this year except the first two.  To say that this year has been a bit of an outlier for economic disappointment in the 15 year history of the series is a bit of an understatement!

While it's worth stressing that the chart represents the data surprise relative to forecast, not the actual growth trend, it's really quite remarkable that an institution that keeps paying lip service to "the data" is finally preparing to hike when said data has disappointed expectations for the better part of a year straight.

While Macro Man has long been an advocate of abandoning ZIRP, even he would concede that from a blank slate now is not the most obvious time to deliver the first rate hike.  While Yellen on Thursday and payrolls on Friday will put the finishing touches on market expectations for this month's Fed meeting, the data will ultimately craft how the market perceives the duration and extent of the cycle.

In fairness, current pricing is exceptionally modest by both historical standards and the Fed's own rhetoric...but once rates go up, there will also be room for them to go down again.  Historically, the dollar hasn't exactly shot out of the blocks at the onset of Fed tightening cycles, which is another reason for caution.  It's true that the current cycle is unique in that the euro has negative interest rates, Japan is doing QE, etc., so there are plenty of reasons to expect that the dollar rally will continue because of the lack of viable alternatives.

In the short run, however, it looks like the bulk of the good news is probably in the price.  Macro Man has therefore cut half of his shorts in both EUR/USD and January Fed funds.   While there is still room for more downside in both, there is also room and potential catalysts for some upside, as well.  Just because the market didn't react yesterday doesn't mean it won't tomorrow.