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.   

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Booger
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December 2, 2015 at 11:42 AM ×

Good article MM, the euro move via Draghi was nice, and who is not up for free money, but it is not good being the last one to chug a puff out of that one. The short interest developing will make for a nice short covering rally of a few hundred pips.

Which makes me wonder where the other end of the short euro trade has been going ? I am looking for an early reversal sign on euro to short dax/ long euro, or long eur.aud.

If the fed has an abortive lift off then that would be a bonus but I reckon the euro will bottom soon after Draghi announces.

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Polemic
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December 2, 2015 at 11:53 AM ×

Totally agree. the divergence-o-meter re expectations of Fed vs ECB has been off the scale but recent US data easing it back a bit.
Working on the rule that FOMC tends to have high variance form pricing going In to them I'll have a fiver at long odds that what ever they do is not as hawkish as market is pricing.

Only thing to watch re EUR/USD is if EM start to fund in CHF and EUR at close to -ve instead of USDs.

While on FX - I have come up with an old lag FX film caper. http://polemics-pains.blogspot.co.uk/2015/12/the-pitch-fix-up.html
Oceans 11 meets FX trading. Pass on to your film producer friends..

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Anonymous
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December 2, 2015 at 11:53 AM ×

re euro- everybody is pointing at extreme positioning but if anything i don't think market short enough given how things have since the ecb announcement at the start of the year.if anything a lot of people are looking at a swift euro reversal- i think surprise could be how hard it falls and get people rushing to sell it. these things overshoot a lot of times and i would not to be surprised to see that here.
still like eu equities over us given relative valuations cb actions etc
and still amazed to see us equities shrugging everything

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December 2, 2015 at 12:18 PM ×

Many of the same themes jumped out to me. Aside from all the currency implications, am now thinking of a much higher probability of a bubble conditions for 2016 and a melt-up....

ISM & Fed implications

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Anonymous
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December 2, 2015 at 12:40 PM ×

Anyone have a view as to why AUD/USD and NZD/USD out-performed recently?

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Booger
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December 2, 2015 at 1:22 PM ×

Anon 11:53, short enough by week end for a good covering reversal I reckon. It depends on what Draghi actually announces, if QE extended more than 1 year or/and more than 0.1% further on the negative rate then there may well be more downside. I will wait for announcement. At some stage the sellers will be out of position and there will be a nice covering rally.

Anon 12:40, for some reason aud.usd developed a massive spec short interest in the last 2 months, that is being unwound. RBA relatively relaxed about any further rate cuts currently but that could change around aud.usd 0.74. Interesting inverse correlation has developed in the last 2 weeks between aud.usd and eur.usd, indicates to me that a significant portion of the aud funding side is coming from euro recently. This was not the case in the last 2 years when euro, yen and dollar block would move in lockstep.
Other theories (which I don't subscribe to) are that
- a fed rate hike via IOER will actually increase monetary velocity and be inflationary and positive for resources
- that the Australian economy has decoupled from China.

A puzzling thing is why there has been increasing divergence between Canada and Australia, with Canada looking like it is slipping back into recession again. Perhaps Australian resources (iron ore) had more volume expansion, to make up for the lower prices thus far which the Canadians (oil projects) have not had that scale up effect. This augers for longer term larger falls in iron ore cf oil, but there might be another leg up in aud.cad in the short term so perhaps long eur.aud (once euro bottoms) is looking better with recent developments.

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CV
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December 2, 2015 at 2:13 PM ×

Completely share the sentiment MM, but I cannot get myself to get in front of Mr. Draghi here. No way. Today's inflation report was more ammunition for the doves. I think they will go for it, in size!

As a result, I am happy to remain well clear of a "contrarian" punt.

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Anonymous
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December 2, 2015 at 2:17 PM ×

FAILURE defined: If you blow €60bn a month on bond purchases & tell everyone it'll produce inflation, but results show only 0.1%

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Polemic
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December 2, 2015 at 2:37 PM ×

It's not failure if the alternative was monster deflation. The 'could of' remains obscured in a parallel universe but we cant say it has been a failure if the alternative would have ben 10% deflation.

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CV
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December 2, 2015 at 2:43 PM ×

Agree with Polemic. Besides, inflation lags ... it will go up in the next six-to-12 months, significantly, no matter what the ECB does.

Hint: Sell the long bond in Germany ;)

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Anonymous
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December 2, 2015 at 3:22 PM ×

2y German Bund yields hit fresh low at MINUS 0.445%

Eurozone CPI rose 0.1% vs est. 0.2% gain. Core CPI unexp slipped to +0.9% from 1.1%.

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Anonymous
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December 2, 2015 at 4:03 PM ×

As a consumer, I would welcome deflation. After years of overproduction spurred by monetary pumping, shouldn't we expect deflation? Sorry, but I can't work up a terror of "the death spiral of deflation."

Rossmorguy

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Anonymous
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December 2, 2015 at 4:41 PM ×

pol 2:37
"It's not failure if the alternative was monster deflation. The 'could of' remains obscured in a parallel universe but we cant say it has been a failure if the alternative would have ben 10% deflation."
enjoy your comments but this i totally disagree with - counter factual
we would still be here without qe and i dont think anybody minds this inflation given wages have been crap - qe is mainly helping those asset rich but forget doing anything for inflation- as boj is finding out as well
that said we are not here to debate benefits or not but market impacts though now its a case of buying coz everybody else is and not sure that is going to turn out all good in the end

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Anonymous
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December 2, 2015 at 5:19 PM ×

@Nico - Good call on suggesting to flatten EU equity longs/go short yesterday. Dax now down 200 odd points since you made that comment.

I never did go short, and will stay on the sidelines until post-ECB, but credit where it's due.

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Mr. T
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December 2, 2015 at 6:21 PM ×

bund futures steamrolling higher. Don't hear a lot anymore about Gross' short of a lifetime. Frankly I think there are better opportunities out there than shorting bunds or generally fighting CB's.

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hipper
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December 2, 2015 at 6:31 PM ×

It's really hard to think sustainable catalysts for the euro. Maybe if the private credit growth continues to accelerate and inflation picks up but without the EM growth tractor pulling it its hard to conceive. Maybe those much discussed global deflationary drivers are really more persistent than most might realize. That's why QE is the equivalent of sticking ones head in the sand. It would also require the public sector to go on a spending spree contrary to what's going on now.

I don't know where it's going and if the widest possible divergence is already priced in but gun-to-head conviction is it's too late to go long USD in any major way. If divergence materialize smaller than expected a modest short covering rally but will then go still on to dip on dip below parity. Of course this is dependent on Fed not doing a Carney. In that case April low marked the bottom. I'm thinking of using GDX as a long USD hedge. Does anyone else think it's carving a nice looking bottom at 13 regardless of gold?

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Anonymous
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December 2, 2015 at 6:40 PM ×

I have been cogitating about what will happen when rates start going up since 2008. It comes as no surprise that every awake investor has now become saturated with the idea that low rates lead to skewing of investments into equities and housing.When rates go up, logically the inverse should occur. Now that Yellen has actually done all but make the first rate hike a fact, it occurs to me that this is a good time to be in cash to take advantage of the short possibilities in equities that should make their appearance later this month. As they say, you don't have to be first to invest in this idea, you just have to be right. Let the first three or four rail cars go by, then when you've judged the speed, might be time to hop on...

As Steve McQueen said in The Reivers "It's time to say goodbye to the things you know, and hello to the things you don't"

I'm not looking for blood in the streets, I'd be happy with just a little ooze to start with..:)

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Anonymous
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December 2, 2015 at 6:46 PM ×

Oh my, ECB Said to Present Economic Forecasts With No Major Revisions, BBG reports. ECB will revise down 2017 inflation forecast to 1.6% from 1.7%
Great work. Go for it.

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Anonymous
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December 2, 2015 at 7:09 PM ×

BBG note stating that portfolio managers are holding the largest pctg. of corporate bonds in history, 35.7% of assets.

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Anonymous
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December 2, 2015 at 7:21 PM ×

Euro looking to break below $1.05 as 2y Bund/UST spread hits fresh 9y high

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Anonymous
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December 2, 2015 at 8:37 PM ×

Everything has sold off today. Everyone is going to cash.

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Nico G
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December 2, 2015 at 8:43 PM ×

anon 519 cheers as said the long trade is very crowded this week. Considering renewed terrorism threats they might block Santa at the border later on which would be plenty ugly so tight stops everyone. Market is fragile under 2077 spoos

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Anonymous
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December 2, 2015 at 9:19 PM ×

@Nico, I'm still recovering from your "bisexual pearl" comment the other day. I'm thinking you are undercover as "The Most Interesting Man in the World" -- right?

- Whammer

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Anonymous
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December 2, 2015 at 9:22 PM ×

@Booger,

Australia might have some cost advantage on mining, Canada does not have an edge on oil production. Oil market is also a lot more competitive than iron ore. Again, these do not matter in FX so the recent divergence might come from the fact that RBA is more hawkish than BOC.

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December 2, 2015 at 10:02 PM ×

Macro Man, curious to hear your take on getting away from ZIRP. If you believe that we should move away from ZIRP, then why wait? What data would force you to say, yes this is a must hike moment. The global economic outlook doesn't look very bright for 2016, if it is global economic headwinds the FED looks at, there won't be an ideal time to raise for quite a while.

Also a quick related question, does the FED run any risk of scaring markets by not hiking? In other words, the market believes the FED knows something that they do not, or that the economy is not as strong as the market believes.

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Nico G
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December 3, 2015 at 2:35 AM ×

Whamner

finishing (astonighing Kavanagh's) biography of Nureyev at the moment - we still have a lot to learn..

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Booger
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December 3, 2015 at 11:40 AM ×

The euro in it's formation is a classic case of putting the cart before the horse. The Fed raising rates at this point would also be a case of putting the cart before the horse. Maybe gold would be a better long than eur.usd.

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Anonymous
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December 3, 2015 at 7:14 PM ×

@Nico, you are certainly more interesting than I, but that is a low bar ;-)

You did prompt me to read a review of that biography, sounds very well done.

-- Whamer

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