Euro short-squeeze or dollar selll-off?

On Monday morning, EUR/USD trading took a slow start of the new week and it looked as if EUR/USD traders should have prepared for an uneventful trading session. There were no eco data on the calendar in Europe and neither in the US. EUR/USD reached an intraday low in the 1.3185 area late in Asia as the dollar continued to profit from higher US bond yields. However, a real test of last week’s low didn’t occur and EUR/USD found a better bid early in European trading. The positive sentiment on the equity markets gave the euro downside protection. However, trading was in the first place order-driven and developed in thin market conditions. EUR/USD had reversed the Asian losses when US traders joined the fray. Even more, the euro short-squeeze accelerated during the US trading hours. Rating agency Moody’s said that the US tax and unemployment benefit package of last week will increase the likelihood of a negative outlook for the US Aaa rating in the next two years. The statement of Moody’s was also no help for the US dollar which was already in the defensive at that time. In addition, US yields nosedived as Treasuries reversed part of their recent losses. All this apparently forced some short-term players to backtrack on USD long positions. Thin market conditions exacerbate the intra-day price swings. EUR/USD reached an intraday high at 1.3434 in US afternoon trade and closed the session the session at 1.3391, quite an impressive gain compared to the 1.3226 close on Friday evening.

We see yesterday’s move in the first place as a technical short-squeeze in thin market conditions. So, we don’t make too much out of it yet. Nevertheless, the move might also contain a warning that the US currency is not completely immune to fundamental weaknesses in the US economy or its policy framework. The institutional deficits of the euro zone are well documented and have got ample coverage in the (Anglo-Saxon) press. They were (and still are) a good excuse to sell the euro when political bickering among European policy makers returns into the spotlights. However, at school we learned that the combination of a loose fiscal and monetary policy at the same time might undermine confidence of foreign investors at some point. Maybe US bonds and the US currency are also not completely immune for this mechanism.

Today, the calendar of eco data is quite well filled. In Europe the industrial production data and the ZEW economic sentiment survey will be published. Markets usually give more weight to the PMI’s and the IFO release, which will be published later this week. So, we expect the impact of the ZEW survey on currency trading to be limited. A reaction to this indicator would tell us more on underlying market sentiment than on investors’ assessment on the economy.

In the US, the retail sales report remains an interesting piece of information on the status of the US economy. The producer prices are probably less relevant for EUR/USD trading. Over the previous days, currency traders didn’t really know to which factor they should focus on. Sometimes, higher US bond yields were seen a good reason to buy dollars. Yesterday, improved risk appetite was again seen a good enough reason for a scaling down of EUR/USD shorts. In addition, the dollar showed some signs of fatigue on the rally that had occurred for most of last month. So, the jury is still out which card markets will play going forward. Will the dollar gain or lose in step with the incoming US data and the subsequent reaction on the bond markets? If so, the dollar should profit from stronger than expected US retail sales. Or will the risk story prevail/return? Last but not least, the upcoming EU summit might still complicate the euro side of the story. So, there are a lot of conflicting issues that might interfere in EUR/USD trading. Given thin end of year market conditions, this might trigger more erratic swings as the one we attended yesterday. After the close of the European markets, the Fed will announce its policy decision. After last month’s ‘big move’ to QE-2 and as the global picture for the US economy hasn’t really changed since the previous meeting, we don’t expect the Fed to bring any high profile message for markets.

Global context. Since early November, EUR/USD is captured in a negative trend. The trade-weighted dollar reached a new correction low (75.63) after the November Fed meeting with EUR/USD reaching a top in the 1.4280 area. However, the negative impact of QE-2 on the US dollar faded soon. The tensions in peripheral Europe came again to the forefront. EUR/USD was ripe for a more pronounced correction. Contagion fears kept the euro under pressure. The pair reached a correction low at 1.2969 last week. Since early December, the tensions on the European markets eased as ECB bond buying gave investors some comfort. This caused a temporary short-squeeze in EUR/USD too. However, the move had no strong legs either. The rebound ran into resistance in the 1.3440 area. Regarding the USD side of the story, the signals were mixed of late. Nevertheless, until yesterday, the US budget agreement and the subsequent rise in US bond yields were seen as USD supportive, at least in the short-term. Yesterday’s short-squeeze brought the pair within striking distance of the early December highs in the 1.3440 area, but a real test/break didn’t occur. The short term picture in the pair has turned more neutral/ indecisive as the pair tries to regain the 1.3334 (previous high)/1.3480 (uptrend line from the year lows) area. We still slightly favour a cautious sell-on-upticks approach for return action south toward the 1.2969 area. However, in current thin market conditions one should be well aware of the risk for more order driven erratic swings.

On Monday morning, USD/JPY traders at first didn’t know which card to play. In Asia and early in European trade the cross rate continued to profit from higher US bond yields. At some point, it even looked as if the pair would go for a retest of the key 84.41 resistance level. However, as was already the case several times over the past two weeks, the test was again rejected and USD/JPY returned south of the 84.00 mark, copying the correction on most other USD cross rates. European equity markets succeed a decent performance and EUR/JPY was also trending higher, but even these pointers of investor risk appetite were not strong reason enough to protect the headline pair. The least one cane say is that the 84.41 resistance level has done quite a good job. During the US trading hours, the dollar continued to lose ground across the board. Negative comments from Moody’s on the US AAA-rating and a decline in US bond yields triggered additional USD selling. The pair closed the session at 83.39, compared to 83.95 on Friday evening.

This morning, Japanese production data (final figures) failed to inspire trading. Most Asian equity markets show marginal gains. This leaves the USD/JPY cross rate in the neighborhood of yesterday’s closing levels. However, we have the impression that the dollar is still struggling to reverse (part of) yesterday’s losses.

After the Mid-September interventions, USD/JPY trading for some time became a tactical game between the BOJ and the market. Investors felt comfortable with yen long positions (USD/JPY shorts) as Japan was considered to have little room of maneuver to execute a strategy of aggressive interventions to stop the rise of the yen. Indeed, the debate in the G20 was about excess countries taking steps to artificially lower the value of their currency. However, finally the global decline of the dollar slowed and USD/JPY developed a bottoming out process. The rise in US bond yields was an important driver behind this move. This improved the ST technical picture in the pair. We didn’t/don’t expect a major U-turn in the USD/JPY cross rate. Nevertheless, there was apparently room for repositioning in a unidirectional positioned USD short/yen long market. Two weeks ago, the 84.40 area was tested several times but no break occurred. We reinstalled a cautious sell-on-upticks strategy for return action to the 80 area. Until yesterday, USD/JPY held up reasonably well. Yesterday’s price action suggests that the US currency is finally losing momentum. We keep stop-loss protection in the 84.50 area to shield USD/JPY short positions against the potential fall-out of a further rise in US bond yields.

On Monday, sentiment in EUR/GBP trading was different compared to last week. At that time, the euro struggled to avoid further losses across the board while sterling kept up reasonably well even as the UK data continued to come out mixed. For one reason or another, investors gave sterling the benefit of doubt. EUR/GBP held close to the 0.8335 support area. The pair was still within striking distance of this level yesterday morning in Asia. However, the tide turned from the start in Europe. EUR/GBP started a gradual rebound, despite quite a series of negative headlines on the EMU in the UK press. European and UK investors reacting to the weak Rightmove house prices (and in particular to the institution’s forecast that house prices may decline 5% in 2011) might have been part of the explanation for the change in sentiment. There was also market talk of M&A driven selling of sterling. A broad-based intraday rebound of the euro and EUR/GBP regaining Friday’s highs in the 0.8405 area, triggered additional stop-tripping of EUR/GBP shorts. These dynamics were extended during the US trading hours. In the afternoon, there were headlines on the screens from a speech of BoE’s Bean. We consider the content of the this speech as broadly balanced. On the one hand, Mr. Bean indicated that one should be attentive to the CPI staying above target for an uncomfortably long time. On the other hand, he kept the door open for a restart of QE in case growth would slow. EUR/GBP closed the session at 0.8443, compared to 0.8368 on Friday evening. Quite a remarkable move given the fact there was no big news to steer the price action.

This morning, the RICS house price balance expectedly rose from -49% to -44%. The impact on sterling trading was very limited. Later today, the DCLG UK house prices and the CPI will be published. The CPI expected to continue to exceed the upper barrier of the BoE target range of 2% (+/- 1%). Even as the BoE governor won’t have to write a letter to the chancellor of the Exchequer to give an explanation for the above target inflation this month, his assessment on the issue is already wellknow. If you are patient and if you remove enough exceptional factors, the CPI will return within the BoE target range at some point. At least for now, the immediate relevance of this release for the BoE monetary policy should be limited. The BoE is in a wait-and-see mode. So, quite a sharp deviation from consensus is probably needed to spark big reaction in sterling.

Global context: from late August till end October, EUR/GBP rebounded from the 0.8200 area to reach a recovery high of 0.8942 on October 25. Investors started to discount higher chances that the BoE would join the Fed and enlarge its program of asset purchases. The harsh UK budgetary measures were seen as a potential drag on UK growth and this could be a good reason for the BoE to maintain an accommodative approach. This kept sterling under pressure. However, stronger eco data (especially the first estimate of the Q3 GDP) torpedoed the hopes for additional BoE policy accommodation short-term and helped sterling to regain ground.

Rising tensions in the euro zone were also a good excuse to scale back euro long exposure in general and EUR/GBP exposure in particular. The pair dropped below the key 0.8532 support area and reached a correction low in the 0.8335 area mid last week. From there, the pair joined the broader rebound of the euro.

Longer-term, we don’t expect a major comeback of sterling (yet). The debate on more QE is delayed, but probably not closed. The impact of the budgetary measures on growth has still to materialize. We still assume that the BoE will lag the ECB on the way to policy normalization. Two week’s ago, the pair showed some tentative signs of bottoming. So, we installed a cautious buy-on-dips approach. Last week, global sentiment on the single currency remained fragile. In addition, the UK currency didn’t trade that bad either. So, the day-to-day momentum didn’t go our way. Nevertheless, we maintained our tactics. We don’t cry victory yet, but yesterday’s rebound gives us some breathing space. Stop-loss protection in the 0.8335 area (correction low) remains warranted to limit the damage in case of renewed intra-EMU tensions (or of further sterling strength)

Full report: Euro short-squeeze or dollar selll-off?