weekly roundup - why does the euro refuse to go lower 1440391-2

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Market Commentary │ March 27, 2014

Weekly Roundup

Tom Fitzpatrick1-212-723-1344

[email protected]

Shyam Devani44-207-986-3453

[email protected]

Dan Tobon1-212-723-1576

[email protected]

For recent commentary or to access archived publications, visit our CitiFX Technicals website: Click here

Chart of the Week – Why does the EURO refuse to go lower?

– Contrary to most consensus views (Including ours) EURUSD has failed to move lower in 2014. Why?

– We think there are some valid arguments in this respect, which fit very well with the historic dynamic seen

in 1997-1998.

– If so then it still remains only a matter of time before market dynamics will reach a point where EURUSD

once again makes a strong move to the downside.

mailto:[email protected]






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Weekly RoundupMarch 27, 2014 2

Chart of the Week – Why does the EURO refuse to go lower?

– Contrary to most consensus views (Including ours) EURUSD has failed to move lower in 2014. Why?

– We think there are some valid arguments in this respect, which fit very well with the historic dynamic seen

in 1997-1998.

– If so then it still remains only a matter of time before market dynamics will reach a point where EURUSD

once again makes a strong move to the downside.

EURUSD long term chart:

Source: Aspen graphics/Bloomberg March 26, 2014.

The long term EURUSD chart shows the similarities with that seen in the last USD cycle throughout the 1990’s

Both rallies were similar in length as were the background economic dynamics (housing boom and subsequentbust in the US in the early 1990’s and again in 2006-2007)

The highs came in 1992 and 2008 and the major developments that followed three years after each of those

highs was a currency crisis in Europe – ERM crisis in 1995 and the European Sovereign debt marketscrisis in 2011.

Within the bear market for EURUSD that came after 1995 we can see there was a decent correction up from August 1997 into October 1998 which saw EURUSD bounce 16.5%

Since the low posted at 1.2043 in July 2012, EURUSD has bounced 16% so far.

As a consequence we believe an important peak has either been put in place or is coming relatively soonwhich would mark a turning point that is likely to send EURUSD back to the 200 month moving average at1.2134

A monthly close below that 200 month moving average (which has limited the three major falls in EURUSDover the past 10 years) would then open the way for much lower levels still over time (Possibly to parity orbelow over the next 2-3 years)

16.5% rally within thedowntrend into October1998At this point peripheral

bond market yields(Italy/Spain) had almostconverged to Germanyacross the yield curve ashad FX rates.

16.0% rally sofar off July2012 low

1992-1995: ERMCrisis

2009-2012:European Bondmarket crisis

91 monthsuptrend

93 monthsuptrend

?






EURUSD 1995-1998 and 2011-2014 - Not identical but pretty similar


When we look at that rally in the EUR (As its components ITL,ESP,FRF etc.) into late 1998 we saw twostrong convergence trades taking place

– FX rates: Following the devaluations into the peaks in early 1995 peripheral currencies eventually

converged in late 1998 to their “entry fixings” in the new single currency.

Deutsche Mark Italian Lira- During ERM crisis and into creation of the EURO


Massive devaluation from 1992-1995 of Italian Lire followed by convergence trade into the Euro fixing rate inlate 1998. That level still left the ITL about 30% weaker than 1992 and combined with the bond market movewas very stimulative. In today’s crisis there has been no scope for an internal FX devaluation in Europe hencethe fiscal austerity program, which is much more damaging domestically.

Peaks in October 1998 with a 16.5% rallyas convergence trade gets close toendgame. Falls 20 big figures infollowing 8 months

Peaks in April 2014 with a 16.0% rally asconvergence trade gets close toendgame?






– Bond yields: Having hit 13.8% in March 1998 and a spread to Germany of about 650 basis points, Italian

10 year yields fell to 3.90% by December 1998- converging totally with German rates. The turning point inthe EURUSD rally of 16.5% (As its components) had effectively occurred 2 months earlier in October1998. The week of that peak in EURUSD the spread between 10 year Italy and Germany closed at 54basis points.(The 2 year spread was about 56 basis points also making the Italian spread to Germany

consistent across the curve).Why is this important? This dynamic clearly showed that as far as the marketwas concerned a single currency pretty much meant a single bond market- hence the ultimate convergence

to ZERO right across the curve 3 months later just before the official launch of the EURO.

For the purposes of this piece we are focusing on Italy (albeit we could just as easily use Spain in this example)

Italy Germany 10 year yield spread/Italy 10 year yields/EURUSD


Between July 1997 into October/December 1998 the market increasingly believed thatwe were heading for one currency and one bond market in Europe. Peripheral yieldsfell in Europe, spreads converged and exchange rates headed towards their fixingrates in the Euro.During this period we were also seeing money come back out of emerging marketcountries (Asia crisis and Russia default) after the prior search for yield makingEuropean peripheral currencies and yields look attractive.






So we had no real value left in the convergence trades and the US curve (Equally weighted 2’s,5’s,10’s spreadbetween Germany and the US) was on average 67 basis points in favour of the US (Compared to 82 today).That meant that once there was no value in playing the convergence trades of FX and yield the US/Europeinterest rate differential/economic dynamic came into play in favour of the US and ultimately the USD.

Equally weighted Germany minus US 2’s,5’s and 10’s yield curve


Between October 1998 and June 1999 we saw the spread move from around 44 basis points in favour of theUS to over 220 basis points

During that same period

– US 10 year yields rose from 4.42% to 6.08%

– US 2 year yields rose from 3.85% to 5.75%

– The spread between US 2 year yields and Fed funds approached 100 basis points in late June 1999

– The Fed began a tightening cycle on 30th June 1999 into May 2000

As you will see in our recent fixed income note (Chart of the Week – QE is dead…long live normalization), thisoverall dynamic is not all that different from how we view US fixed income in the months ahead.

Oct 1998

June 1999

Oct 2013

?

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The problem we see this time is that there is no way (in our view) we would expect the market (peripheralyields) to converge all the way to German yields again, especially in the longer end of the curve. It is obviouswith what has happened in recent years (Default in Greece and deposit confiscation in Cyprus) that there isnot a single bond market in Europe. While the premium at the short end of the curve (2 year) is now backclose to those levels seen in 1998 at 68 basis points (compared to 54 in October 1998) the spread at the

longer end (10 year) stands at 177 basis points (compared to 54 basis points in October 1998). This showsthat while concerns are alleviated in the near term the overall “issues” are still a concern.

Italy minus Germany 2 year yield spread


The peaks seen in 1995 (724 basis points) and 2011 are very similar and we are now very close to the levelsof October 1998 (56 basis points) and also the lows off which the major move higher began in 2011(April 2011lows of 56 basis points)

Italy minus Germany 10 year yield spread


In 1998 this spread peaked at around 650 basis points compared to around 550 basis points in 2011(Albeit offa much lower level of yields)

By October 1998 it had fallen to 61 basis points whereas today it stands at about 176 basis points. The surgehigher in 2011 came from levels around 122 basis points. While a move towards that level (About another 50basis points) may be possible, we doubt we can continue to converge like we did in 1998.

1995 peak 2011 peak

October 19982014 low so far

1995 peak

October 1998

2011 peak

2014low sofar






So at what point in this cycle does the “value proposition” no longer provide support for the EURO. We do notbelieve that this number is Zero (Spread between Italy and Germany right across the curve) for the reasonsabove but we do have a subjective view as to when those “alarm bells” should ring.

Right now Italy has a spread of 68 basis points to Germany in 2 year rates and 38 basis points to the US. In

the 10 year period those spreads are 175 basis points and 60 basis points respectively. For somebodylooking to take advantage of this dynamic you pretty much have 3 scenarios

– Domestic European investors can play the convergence trade between Germany and Italy…but for howmuch longer as these spreads contract? There is no underlying FX trade here.

– Foreign investors can play this convergence trade hedged. Now, normally a hedged trade would be a

Zero sum game if the hedge went to the maturity date but this is not a normal setup. At present a US

investor could get about 84 basis points to invest in 2 year Italian notes. This compares to about 45 basis

points in the US (So almost double the yield to take the short term bond risk). In a normal World hedging

this would make this a zero sum game and the cost of forward cover (buying and selling EURUSD) would

equate to around the difference of 39 basis points per annum. However, the forward points on EURUSD do

not reflect the interest rate differential between the US and Italy but are more closely aligned with German

rates. As a consequence you RECEIVE about 72 pips when you buy and sell EURUSD spot to 2 years out

thereby you RECEIVE about 26 extra basis points per year giving you a yield of about 110 basis pointscompared to the 45 basis points in the US. Again, there is no underlying FX trade here as it is just an FX

swap thereby hedging FX risk.

– Despite the fact that neither trade above has an actual FX component they both contribute to the

convergence trade which is one of the main things we believe has encouraged EUR buying (As we saw in

1997-1998). As a consequence the 3rd

trade is the buying of peripheral bonds unhedged in the belief

that you gain from

The directional move in the bonds/notes (Italy)

The outperformance to both US and Germany by Italian bonds

An FX gain

– So overall the unhedged investor looks to get paid for all aspects of the risk being taken. When is this not

the case? Once Italian yields converge to US yields (If they do) then a USD based investor no longer gets

paid to take that bond risk…so why would you? Combine that with the compressed spreads with Germany

today being close to those seen in October 1998 (2 year) and the belief that risk “premia” will prevent anarrowing at the 10 year area to Germany like we saw in 1998 and we have to believe the peak in the bond

trade/convergence trade and thereby the EURUSD trade is close.

– In our view, if and when these rates converge/or get very close to converging with US rates it no longer

looks like an attractive trade. At that point the spread chart above of the US versus German curves could

well come into play just as it did in 1998-1999.






Italy minus US yields (10’s and 2’s)


As the Italian-US 10 and 2 year spreads converged from 2009-2010 (red arrows) towards zero and about 25basis points respectively, EURUSD ignored the move and continued during the same period.

That changed in both instances at around 60-80 basis points where EURUSD topped out before fallingfrom above 1.51 to below 1.19 over the following 7 months. EURUSD therefore turned lower before the full (or

as close to full as it was going to get) convergence took place. The high so far in this EURUSD move was posted at 1.3967 on 13

th March .On that day the 10 year

spread stood at 79 basis points and the 2 year spread at 57 basis points.

Given where the spreads currently are, this suggests that the move could well have already run its course tothe topside in EURUSD but if not that it is very close.

Given that we think US yields can soon head higher again both in the 2 and 10 year periods this would likely only

serve to exacerbate the situation by either:

Dragging peripheral yields with them or

Narrowing those spreads even further

Neither scenario should be good for the Euro.






– We believe, as noted in our Weekly Roundup last week titled “QE is dead…long live normalization” that aplatform is forming for a move higher in US yields. Initially we expect this to be led by the “belly” of thecurve (5 and 10 year) and ultimately look for the 2 year to “take up the running”. It is at this point that we

strongly believe that the trade above (FX and fixed income convergence) will have fully run its course and

open up the way for the next material move down in EURUSD that could see us close to parity in the next 2

or 3 years. (As per our recent bulletin titled “The long term USD rally begins”.

– On top of this there are some important EURO specific dynamics that bear looking at. One is the

monetary/inflation dynamics in Europe and how EURUSD has affected that. The other is the argument that

Europe is potentially the next Japan (We agree) and therefore the EUR is going to be very strong in a

depressed economic/deflationary environment (We disagree).

Brent Oil in EUR terms/ Harmonised EU consumer prices/ ECB rates. No deflation Mario? Really?


As we can see the sharp rise in CPI in 2007-2008 was led by a sharp Oil price rise and culminated in amisguided raising of rates by the ECB

Oil then collapsed in 2008 leading to a collapse in inflation and economic activity leading to a sharp ease bythe ECB

Then, following the 2010-2011 surge in Oil prices followed by a surge in inflation the ECB made exactly thesame mistake and tightened again. This is where it is different this time. Despite the easing of ECB rates from

Brent in EUR terms

HarmonisedEU inflation

ECB rates














1.5% in 2011 to the present 0.25% level and the absence of any drop in the Oil price inflation has collapsedfrom 3% to 0.7% and sits at the lowest levels since late 2009

This suggests that something much more structural is at work and is totall y at odds with the ECB’s no chanceof deflation assertions. If they are not worried they should be.

– There is now little scope for further traditional easing as we sit at 25 basis points already.

– ECB deposit rates are already at Zero (25 basis points under lending rates) with no discernible effect. So

talk of negative nominal deposit rates seems “moot” as an effective rather than psychological tool.

– Renewed direct asset purchases by the ECB would almost certainly need a number of things to be a

credible stimulus

Broad based on some GDP weighted formula including Germany

Put in place with no austerity requirements

Not associated with any preferred creditor status for the ECB

– The problem with this is that it in effect would create a de facto single bond market with joint and several

liabilities among Euro nations (Bonds would be on ECB’s books) and it is not clear that Germany is yet (Ifever) prepared to sanction this.

So where does that leave scope for stimulus? The exchange rate. To us it is no coincidence that all themonetary policy rhetoric we have heard from the ECB officials in recent months has come as the EURO hasmoved higher. The chart below supports this contention , in our view






Euro monetary conditions index as at Dec 2013.

MCI: Monetary conditions index: This peaked in Aug 2012 (Loosest point of the MCI cycle which startedeasing in Feb 2008).

RIR: Real interest rate: Also eased dramatically since 2008 and was loosest around the same time as theMCI was at its high. It has since marginally contributed to a tighter MCI.

REER: Real effective exchange rate: Has moved down totally in tandem with the MCI. In Feb 2008

EURUSD was at 1.6020 and peaked at 1.6040 in July. In July 2012 it was at 1.2043. It hit 1.3967 (16% riseby March 2014 having been at 1.3893 in Dec 2013, the last month with this data.

It is clear from the chart above that the overwhelming contribution to tighter monetary conditions has been theexchange rate followed by falling inflation (Causing real interest rates to rise) and that Europe now desperatelyneeds a weaker currency to help stimulate the monetary conditions gain.

After Draghi came out with the rhetoric of “we will do what is needed to preserve the Euro and it will beenough” (July 2012) EURUSD unfortunately did exact ly the opposite of what was needed and has rallied 16%since that month. Now despite repeated rhetoric (In a misguided attempt to avoid action) designed to stop theEuro moving higher it remains at exactly the same level as it was at in December 2013 when the data abovewas last made available. (Remember 2008 when EURUSD peaked at 1.6020 and then at 1.6040 3 monthslater before turning)

Feb 2008

Aug 2012






So what can they do? As we noted above…not much . At best the psychological effect of moving fromnegative real rates to negative nominal rates accompanied by a statement that the strength of theEURO is tightening monetary conditions and increasing the deflationary risks might be sufficient toturn the currency lower.

There is also a sea of opinion that says a recessionary European economy with deflation and a high currentaccount surplus is reminiscent of Japan and would likely send the Euro higher .We agree on the concernsabout the outlook but not the conclusion

– Japan was and is one economy with one bond market and a central fiscal system. Europe is a gathering of

separate countries with different bond and fiscal systems and no fiscal transfer mechanism.

– In tough times Japan tends to act together like “Japan Inc.” while Europe gets territorial and Nationalist

– Japan’s current account surpluses were Japan’s surpluses. Germany is the primary surplus nation in the

Eurozone and it is not likely to be “gifting” those surpluses externally anytime soon . When it comes to the

periphery recent surpluses are more to do with falling imports than economic health.

– Japan has one banking system. Europe cannot even agree on a pan European bank deposit guarantee

system. – As the backdrop deteriorated in Japan they moved to a QE approach which they have revisited recently but

they did not default despite rising debt levels and financed that debt predominately internally. When the

backdrop deteriorates in Europe they “take your money” through default and deposit confiscation. (Neitherof which policies they rule out going forward). This default without devaluation fails to economically

stimulate especially as it is accompanied by austerity measures.

– This suggests that the Euro goes down as part of the solution (Good weakness and our preferred and likely

scenario) or as a renewed part of the problem (Bad weakness, economic and political fragmentation, social

discord, haircuts and confiscations which would almost certainly result in the ultimate demise of the Euro).

This is neither our preferred or expected scenario but more of a tail risk event.

Conclusion:

We are no less convinced than we were at the start of the year that EURUSD is going to head muchlower over the coming years

We anticipated this move would already have begun at this stage yet we sit at almost the exact levelwhere we closed 2013

We believe the “day of reckoning” is not far away and that as detailed above the building blocks are nowfalling in place. We may have already peaked with the marginal new high posted at 1.3967 this month buteither way we are skeptical of any sustainable move over 1.40 materialising and still believe that we maysee EURUSD much closer to 1.20 than 1.40 before this year is behind us.






Portfolio update:Position,

Instrumentand date

CommentEntry

price, stopTarget

Exit date andprice

Profit/Loss% of

Capitalused

Long USDJPY06 March 2014

Turning higher just shy ofgood supports

Daily momentum also turnedhigher from historicallystretched levels

102.74S/L: 99.75

105+ andthen 110

---- ---- 20%

Long USDJPY07 March 2014

Bullish break confirmed aswas a bullish outside weekon the Nikkei. US yields arealso likely to move up whichis likely to support USDJPYon the margin

103.32S/L: 101

110 ---- ---- 20%

Total Capital Used 40%

Source: Aspen Graphics / Bloomberg March 27, 2014.






Short-term conviction views1:

Instrument View / CommentDate

EstablishedTarget Level today

Gold

Bullish weekly reversal and weeklymomentum crossing up as webounce from the lows set in 2013

A decent bounce should be seen to$1,433

06 Jan 2014

Initial target met($1,361)

Next target:$1,433

$1,292

USDTWD 17 Feb: Remains above the reverse

head and shoulders breakout levelat 30.20-24. Uptrend still in place

27 Jan 201430.71 and then

31.5430.55

Brent

Updated comment 24 Mar: Held the200 week moving average againand is likely to rally to the double

bottom neckline at $112.39

10 Feb 2014 $112.39 $107.68

USDJPY 76.4% retrace against the lows and

a bullish outside week suggest arally to the trend highs again

10 Mar 2014 105.45 102.14

US 30 year yield

Good hold of support levels in the3.50% area and outside week alongwith a double bottom pointstowards a test of the 4.00% area

Comment: 17 March: Hammerpatterns across the curve indicatehigher yields

10 Mar 2014 4.00% 3.52%

AUDUSD

Higher highs and a close above the200 day moving average indicatesa move to the reverse head and

shoulders target at 0.95

26 Mar 2014 0.95 0.9258

Source: Aspen Graphics / Bloomberg March 27, 2014.

1 Convictions represent the views of the CitiFX Technicals staff and not actual trades.






Contacts

Global Head of Value Added Services & Products

Stephane Knauf London 44-20-7986-9486 [email protected]

Corporate Solutions Group

Joakim Lidbark London 44-20-7986-1585 [email protected]

FX Technicals

Tom Fitzpatrick New York 1-212-723-1344 [email protected]

FX Strategy

Steve Englander New York 1-212-723-3211 [email protected]

Quantitative Investor Solutions

Kristjan Kasikov London 44-20-7986-3032 [email protected]

Value Added Products

Nicolas Thomet New York 1-212-723-6014 [email protected]

Published by: CitiFX Wire

27 March 2014

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