Watch For A ‘Deep Dive’ In The Euro

Some folks are sounding pretty bearish on the euro of late, and it’s not hard to understand why.

The common currency rallied hard against the greenback  in the first nine months of 2017, as a policy divergence story (hawkish Fed/supportive fiscal policy in the U.S. versus political risk in Europe and a dovish ECB that, to the extent they moved towards normalization at all, would be starting from behind anyway) morphed unexpectedly into a policy convergence story (lackluster inflation in the U.S. keeping the Fed gun-shy/stumbling block after stumbling block for Trump’s growth-friendly agenda versus receding political risk in Europe and a suddenly “hawkish” Draghi at Sintra).

That led to a truly hilarious reversal in positioning. You can see it in light blue below:

USD

Well now, despite the expected announcement of the ECB taper, it’s looking like the tables might turn again. With “progress” (or what counts as progress these days) on tax reform in the U.S., with the Fed hell-bent on squeezing in another hike this year, and with political turmoil in Italy and Spain raising the specter of euro breakup, there’s a palpable sense that EURUSD could be heading for a decline. Here’s Bloomberg’s Mark Cranfield:

Forex markets may look relatively calm, but that just masks the potential for a deep dive in EUR/USD. Political angst in Europe thanks to Catalonia and Italy contrasts with the growing optimism in Washington that a tax deal is possible.

That means the euro may not have to wait much longer to see the 1.16 handle.  The ECB meeting this week is set to announce a tapering of bond purchases, but that will likely be wrapped in the most dovish language possible. Not something designed to bring much support to the euro. The October low at 1.1670 is the next level below which medium-term bulls could be forced to throw in the towel.

As we noted earlier, the periphery jitters are manifesting themselves in European equities. Have a look at the divergent paths European stocks have taken month-to-date (DAX, CAC, EuroStoxx on top, MIB and IBEX on bottom):

Europe

It seems unlikely, given this backdrop, that Draghi would risk coming across as overly hawkish and besides, a little euro weakness wouldn’t be the worst thing in the world (for European stocks anyway) after this year’s run-up. For what it’s worth, we’ll leave you with Goldman’s take from a note out Monday afternoon…

Via Goldman

The ECB meeting on October 26 is capturing a lot of investors’ attention as the ECB is likely to announce the start of QE tapering but also give more forward guidance on rates. Since the last ECB meeting, the EUR depreciated by 2% against the USD and according to our FX team some of the drivers of EUR appreciation have started to reverse. The recent tensions in Catalonia coupled with German election results and Italian election concerns has also led to heightened European political risk and further weighed on the EUR. Inflation also remains well below target supporting the ECB maintaining a dovish tone and mis-valuation from interest rate model fair value is likely to close at this point. Since the last ECB meeting the cross asset response has seen European equities benefiting from the weaker EUR and European bonds outperforming US treasuries, also due to strong US economic data (Exhibit 1).

GSECB

But periphery bonds and equities have underperformed the core, reflecting political risk. From this week’s ECB meeting, our economists expect the ECB to announce a 12-month tapering (end-date by 2018) reducing its monthly rate of purchases to €30 bn and maintaining its forward guidance that policy rates will ‘remain at their present levels well past the horizon of the net asset purchases’. Cross-asset volatility has not repriced materially ahead of the ECB meeting although it is a key event until year end. FX and rates volatility have actually come down. Our FX team forecasts that EUR/USD will fall back to 1.15 by year-end – we like positioning via FX volatility where term structure is flat and as political risk seems underpriced. A weaker Euro can also provide further relief to European equities and we see opportunities for non-US short-dated calls such as the EURO STOXX 50 where vol is now cheap compared to US

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