- Euro bulls remain committed to tapering, with speculator positioning at multi-year highs
- Short-term rebound can continue thanks to help from Lautenschlaeger's comments
- Longer term picture is less optimistic, with growth, monetary policies and politics weighing on the euro
In spite of the recent downturn in the euro’s fortunes and the referendum-related drama unfolding in Catalonia, euro bulls remain committed. Looking at recent futures data, long euro positions are at multi-year highs and have been elevated since last July. Despite no clear indications that the ECB is set to taper its quantitative easing program, expectations remain high. With the threat of an EU breakup in distant memory, euro bulls point to good economic growth, the shortage of high quality bonds to purchase and political unity as reasons for the ECB to change tack on QE. An overview of recent futures and options positioning in euro contracts is shown below for reference.
Still loving the euro, but waiting on Mario
Short-term euro rally has enough catalysts to keep going
Last week, we warned that the euro was looking fairly oversold in the short-term, and particularly against the US dollar (which looks overbought). While being oversold doesn't always mean a rebound is imminent, the euro didn't need a lot of reasons to trade higher this week. Yesterday, the ECB's Lautenschlaeger (who is an executive board member) commented that “from my point of view, it is important that we really move towards the exit – step by step, but steadily and in a clear direction.”
While Lautenschlaeger is usually much more hawkish than her ECB peers (she has broken ranks in the past by criticizing the quantitative easing program), her comments were enough to catalyze a short-term rebound. We upgraded our short-term outlook on the euro to neutral last night, and the currency has since moved higher. Looking at EUR/USD, the pair made its most recent low on October 6 slightly above 1.17. Since then, the exchange rate has strengthened for the last three trading days, and briefly rose above 1.18 earlier today.
As excitement builds for Draghi’s speech later this week, the current rally can continue as speculators remain committed to the 'imminent tapering' narrative.
Longer term picture is less optimistic
In the longer term, factors that are powering the currency today (good economic data, monetary policy tailwinds and lower political uncertainty) are less likely to keep improving in the future. Looking at growth, the Eurozone has been delivering strong economic growth for many years now. Despite the extraordinary actions on the ECB, which have helped prolong the boom by lowering the cost of credit, the market is discounting any slowdown in the future. Our belief is that the inevitable reversal of the economic cycle is much closer than what the consensus believes today, which could lead to a lower euro in the quarters to come. Looking at economic data, growth is already reversing in weaker Eurozone countries such as France and Portugal.
Looking at monetary policy, investors believe it is only a matter of time until the ECB tapers its quantitative easing program and normalizes interest rates. As the ECB comes closer to hitting its own pre-defined limits, markets have taken the opportunity to front run a potential tapering announcement. While this logic appears sound, there is danger in accepting that monetary policy normalization is 'inevitable'. Most obviously, the ECB has leeway to surprise the market by re-writing its own bond buying guidelines. With inflation below target and a strong euro, this would allow the ECB to extend QE, and reverse some of the currency's recent gains.
Common currency at a turning point
Thus the common currency is at a turning point today. If the consensus is right, the ECB will announce curtailing its quantitative easing program at its meeting on October 26. This will support the euro, and the currency can stay supported at current levels and may even resume its upwards march. If the consensus is wrong, the ECB can extend QE by citing low inflation and re-working the program to include a broader range of securities to purchase. Our belief is that the consensus view is dangerous when looking at the longer-term, and that euro weakness is more likely in the future.