Monday, 22 September 2014

22nd Sept

It's been hard not to notice the flurry of new EURUSD targets from the sell-side, notably last week with Goldman Sachs targetting an eventual parity (chart). More recently, Citi suggesting the ECB itself is looking for the EUR to drop to the 2012 lows.

We suspect that the ECB is targeting a reversal of the EUR rally that started after the EURUSD hit a multiyear low of 1.2043 in June '12 - Citi

I can begin to see where they are coming from, very simply, if we regress short end rate differentials to the EUR, based on the last few years inter-relationship, then we can somewhat forecast going forward based upon the enormous divergence in monetary policy that will likely play out over the coming years. Of course, the relationship will come and go, US rates won't rise in a straight line and who knows if we ever get that 1st FF hike next year. But either way, its rather clear that, at least from an interest rate perspective, the EURUSD is very susceptible to fall in the coming years.

Using a simple 2y rate model, we can forecast a 1.07 EURUSD for 2 years time, using the spread between 2y2y fwd starting swaps. But like I said, its not going to happen as cleanly as that, but the magnitude of downside isn't *that* ridiculous.

However, I care much more about where the EUR is going in the next few months, not years. So lets look at that.

CESI spread vs 70-day change in EURUSD
 Here we have a chart of the spread between Euro-area and US Surprise indicies, plotted against the 70-day change in EURUSD. The EUR is clearly stretched at current levels, and it would seem that the data flow is starting to edge against further downside.

EUR vs model FV

 And as we can see from this chart, The EURUSD is at extreme "cheap" levels against my FV model, with a sizeable divergence between the two recently. However, as is the case with models, it may stay diverged for a long period of time or the relationship that we've seen over the past few years may dissipate etc. But, it is worthy of note to me.

I still see Sovereign QE as a likely inevitability from the ECB, but not for a while, so until year end I expect little from them. From the fed, the prior FOMC was quite interesting. A hawkish shift in median dots, yet Yellen clearly stated that the Futures market aren't out of line with the dots. Given that they are massively out, we can only draw from that the location of Yellen's projections in the 2016 and 2017 periods (I circled them)

So while we will get a lift-off in rates, It's kinda pointless to look at the "trimmed mean" or median or whatever. Just focus on Yellen's.

2yr futures net positioning (CFTC)
Investors, have flipped to the most short in years for the 2 year futures, so much like with EDs we have an obstacle in our way.

Lastly on the EURUSD, looking at DXY bigger picture.

Trading up against resistance, now is a critical juncture for the USD, and while longer term the picture is clearly bullish, we've had 10 weeks of  advance and no meaningful pullback. A good reason for this really, with this move taking most by surprise, investors are jumping in at even a 50 point pullback so as not to miss the move. In EURUSD, huge selling interest on anything above 1.30, so if we do bounce. It won't be for too long.

On to a little look at some precious metals, we've seen quite a sharp move higher in 5 year real rates. Many expected 0 to at least slow us down, yet we're already 12bps past that now. The outlook for higher real rates also makes sense somewhat, so while we may pullback, it might be shallow.

The relationship with Gold and Silver is very well documented, and well known, and we can see so far this year, the two track each other nicely.

US 5y real rate (inverted) vs Gold
The outlook also doesn't particularly look that pretty in Gold (or silver)

To me, being long XAU vol here seems to make sense. If we break lower than 1200 we're certainly going to trigger a lot of stops on our way down to 1050, if we reverse, investors that have chased this lower against the 1200 level could quickly cover. Hence a 3 month straddle seems pretty attractive to me.

Otherwise, last post for a while (I assume). Moving into uni next week so quiet from me.

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