## EURCHF is the FX ‘value’ trade according to PPP

Unlike bonds or equities, currencies do not carry any fundamental value and have historically been known as the most difficult market to predict. In our FX fair value model page, we look at different ways of estimating a ‘fair’ value for a bilateral exchange rate. One of the simplest models is based on the Purchasing Power Parity theory, which stipulates that in the long run, two currencies are in equilibrium when a basket of goods is priced the same in both countries, taking the account the exchange rates. We know that the OECD publishes the yearly ‘fair’ exchange rate based on the PPP theory or each economy.

Based on the OECD calculations, it appears that the Euro is the most undervalued currency among the G10 world relative to the US Dollar, as PPP prices in a fair rate of 1.42 (implying that EURUSD is 18% undervalued). On the other hand, the Swiss Franc is the most undervalued currency (+26%). Therefore, if we were to believe that exchange rates converge back to their ‘fundamental’ value in the long run, being long EURCHF is the position with the most interesting risk premia among the DM FX world.

## FX Cross-Currency Basis Swaps and Hedging Costs

One interesting topic in the FX market that has been closely studied by both academics and practitioners over the past decade is the violation of the covered interest parity (CIP). CIP is a textbook no-arbitrage condition that states that interest rate differential between two currencies should equal the differential between the forward and spot exchange rates. In other words, in discrete time, we have the following condition:

Where S is the spot exchange rate, F is the forward exchange rate, i is the domestic interest rate and i* is the foreign currency interest rate. The problem is that the above equation has held since the Great Financial Crisis; as it started to become more expensive to borrow US Dollars against most currencies during periods of stress, the cross-currency basis swap (CCBS) has been diverging from zero for the Euro, the British pound and the Japanese Yen. Figure 1 (left frame) shows the evolution of the 3-month CCBS for the three currencies (against the USD) since 2012.

Low interest rates combined with the significant divergence in unconventional monetary policies run by the BoJ and ECB over the years has put pressure on the exchange rates and the CCBS, and therefore has increased the hedging costs for Euro and Japanese investors. The current rate on the US 10Y Treasuries (3.15%) looks certainly very interesting for unhedged international investors (relative to domestic bonds such as in the Euro area or Japan), however changes drastically when we adjust for hedging costs. Figure 2 represents the cash-flows that occur at the start, during the term and at maturity when a Euro investor (A) enters a cross currency basis swap. As you can see, each quarter A pays the 3M USD Libor and receives the 3M Euribor and the basis. Hence, the more negative is the basis, the higher the hedging cost. With the 3M Euribor at -0.316%, the 3M CCBS at -44bps and the 3M Libor USD at 2.61%, the current return on a FX-hedged 10Y US Treasuries is negative (-20bps). Figure 1 (right frame) shows that despite the rise in US yields since the middle 2016, it has been falling for Euro and JPY investors after adjusting for FX hedging costs. A UK investor would get an annual return of 1.35%, which is 15bps below he can get in holding a 10Y Gilt.

Figure 1

Source: Eikon Reuters

Figure 2

Source: BIS

## Great Chart: Italy EPU Index vs. 10Y Bond Yield

The recent results in Italian’s election held on March 4th wasn’t really a surprise for market participants, with EURUSD barely moving (the pair is actually up 2.5 figures over the past week) and the 5Y CDS spread (vs. Germany) flat at around 92bps (here). According to the latest estimates, the populist Five-Star movement, created by comedian Beppe Grillo and led by its prime ministerial candidate Luigi di Maio, came in first individually capturing 32.7% of the votes. However, if we look at the coalitions results, the Center-Right coalition got 37% of the vote shares, with the alliance including the League with 17.4%, former prime minister Silvio Berlusconi’s Forza Italia (14%) and the Brothers of Italy (4.4%) and US with Italy (1.3%) parties. The disappointment was for the Democratic Party, which has governed Italy since 2013, as the Center-Left coalition captured ‘only’ 23% of the vote shares (much lower than the 27+% estimates, here), prompting former PM Matteo Renzi to step down as party leader. The FT published an interesting graphic lately, showing the geography of the electoral vote: Italy, the politically divided country (here). As you can see it, the Five-Star movement made the largest gain in the South (including Sardinia), in regions with the lowest per capita income.

Hence, following the election results, an interesting chart to watch in the weeks to come is the 10Y Bond yield vs. the Italy EPU index. As a reminder, the Economic Policy Uncertainty (EPU) index was developed by Baker, Bloom and Davis (2016) as a measure of economic policy uncertainty based on newspaper coverage frequency. The authors studied the evolution of political uncertainty since 1985 across countries (12 including the US) using leading newspapers that contain a combination of three of the target terms: economy, uncertainty and one or more policy-relevant terms (For the European EPU index, the author used two leading newspapers per country). Since its inception, the index has gained popularity in practice, measuring another form of market’s volatility or uncertainty. Baker et al. found that elevated political uncertainty has negative economic effects, which can potentially impact market prices.

This chart plots the EPU index versus the Italy 10-year bond yield. We can observe an interesting correlation between the two series. Since the financial crisis, it looks like LT sovereign yields have been rising when the EPU index increased ahead of a political or economic uncertain event. For instance, during the European debt crisis of 2010 – 2012, the EPU Index for Italy rose from 75 to over 200, while the 10Y yield skyrocketed from 4% to 7%. The financial meltdown in the Euro area was then halted after ECB Draghi’s “Whatever it takes to preserve the Euro” famous words at a global investment conference in London on 26 July, 2012.

As we mentioned in our previous posts, we don’t see any imminent risk for Italy, however a potential threat to investors would be a prolonged period of political instability. The question now is: can a rise in Italian LT yields in the next few months lead to a contagion to other peripheral countries’ bond yields (i.e. Spain or Portugal, here)?

Chart: Italy EPU Index (lhs) vs. 10 bond yield

(Source: Eikon Reuters, policyuncertainty.com)

## Great Chart: SP500 vs. US 2Y10Y Yield Curve

Historically, research has shown that the difference between long-term and short-term interest rates (‘Yield Curve’ or ‘Time Spread’) has shown some significant negative relationship with subsequent real economic activity in the United States, with a lead of about four to six quarters. Hence, with the current low levels of the US yield curves (2Y10Y or 5Y30Y), we chose today this week to overlay the 2Y10Y yield curve with the SP500.

If we say that low yield curves tend to predict recessions, then the question now relies on quantifying a low level of the yield curve. We hear from many analysts that the current levels are very low, however if we look back at 40 years of data, the US yield curve levels are not that far away from their long-term averages. For instance, the 2Y10Y and 5Y30Y slopes are currently trading at 51bps and 53bps, while their LT averages stand at 95bps and 82bps, respectively (see here). One main reason why yield curves have been crashing over the past few months is mainly due to an increase in the front-end of the US curve on a back of a shift in expectations of monetary policy. The US 2Y interest rate is now trading at 1.96%, its highest level since September 2008. On the other hand, the 10Y yield stands at 2.46%, has been ranging between 2% and 2.6% over the past year and is up 110bps from its historical low of 1.36% reached in July 2016.

The chart below shows the importance that even if the yield curve turns negative in the US, the equity market has still upside potential in the following months. In our first observation, the 2Y10Y time spread went negative in February 2000, while the SP500 continued its rally and reached a peak in September the same year. In the second one, the yield curve inverted in June 2006 (if we ignore the Jan-Mar 2006 episode) while equities continued to rise for more than a year, peaked in October 2007, and the US plunged into the Great Depression in December 2007.

We don’t think that the current levels of the yield curves are actually alarming for the US economy and we may see a potential floor in the first quarter of this year as we believe that market participants’ (over)excitement on the Fed potential hikes will ease in the medium term. The probability of 4 or more hikes has soared to 12.1%, which pushed the front end of the US curve on the upside and explains the sharp flattening we saw in 2017 (from 1.27% to 0.5%). However, if we look at the EuroDollar futures market, the December 2018 contract currently trades at 97.81, suggesting that investors are pricing in a ST interest rate of 2.19% by the end of the year (see here). This analysis also confirms our bearish view on the US Dollar for 2018 (especially against the Euro).

Chart: SP500 (yellow, rhs) vs. US 2Y10Y Yield Curve (Source: Reuters Eikon)

## FX positioning ahead of the September FOMC meeting

As of today, most market participants are getting prepared [and positioned] for the FOMC meeting on September 20/21st in order to see if policymakers stick with their Jackson-Hole hints, therefore we think it is a good time to share our current FX positioning.

Fed’s meeting: hike or no-hike?

We think that one important point investors were trying to figure out the last Jackson Hole Summit last week was to know if US policymakers were considering starting [again] their monetary policy tightening cycle after a [almost] 1-year halt. If we look at the FedWatch Tool available in CME Group website, the probability of a 25bps rate hike in September stands now at 18% based on a 30-day Fed Fund futures price of 99.58 (current contract October 2016, implied rate is 42bps).

(Source: CME Group)

In addition, if we look at the Eurodollar futures market, the December Contract trades at 99.08, meaning the market is pricing a 1% US Dollar rate by the end of the year. We can clearly notice that the market expects some action coming from US policymakers within the next few months. However, recent macroeconomic data have shown signs of deterioration in the US that could potentially put the rate hike on hold for another few months. Following last week disappointing manufacturing ISM data that came out at 49.4 below its expansion level (50), ISM Service dropped to 51.4, its lowest number since February 2010 and has been dramatically declining since mid-2015. We strongly believe that there are both important indicators to watch, especially when they are flirting with the expansion/recession 50-level. We can see in the chart below that the ISM manufacturing PMI (white line) tracks really ‘well’ the US Real GDP (Annual YoY, yellow line), and as equity markets tend to do poorly in periods of recession we can say that the ISM Manufacturing / Services can potentially predict sharp drawdowns in equities.

Chart 1. ISM – blue and white – and Real US GDP Annual YoY – yellow line (Source: Bloomberg)

Another disappointment came from the Job market with Non-Farm Payrolls dropping back below the 200K level (it came out at 151K for August vs. 180K expected) and slower earnings growth (average hourly earnings increased by 2.4% YoY in August, lower than the previous month’s annual pace of 2.7%).

This accumulation of poor macro figures halted the US Dollar gains we saw during the J-Hole Summit and it seems that the market is starting to become more reluctant to a rate hike in September. The Dollar Index (DXY) is trading back below 95 and the 10-year rate is on its way to hit its mid-August 1.50% support (currently trades at 1.54%). What is interesting to analyse is which currency will benefit most from this new Dollar Weakness episode.

FX positioning

USDJPY: After hitting a high of 104.32 on Friday, the pair is once again poised to retest its 100 psychological support in the next few days. This is clearly a nightmare for Abe and Kuroda as the Yen has strengthen by almost 20% since its high last June (125.85). If we have a look at the chart below, the trend looks clearly bearish at the moment and longs should consider putting a tight top at 105. we would stay short USDJPY as we don’t see any aggressive response from the BoJ until the next MP meeting on September 21st.

Chart 2. USDJPY candlesticks (Source: Bloomberg)

EURUSD: Another interesting move today is the EURUSD 100-SMA break out, the pair is currently trading at 1.1240 and remains on its one-year range 1.05 – 1.15. As a few articles pointed out recently, the ECB has been active in the market since March 2015 and has purchased over 1 trillion government and corporate bonds. The balance sheet total assets now totals 3.3 trillion Euros (versus 4 trillion EUR for the Fed), an indicator to watch as further easing announced by Draghi will tend to weigh on the Euro in the long run. The ECB meets in Frankfurt on Thursday and the market expect an extension of the asset purchases beyond March 2017 (by 6 to 9 months). We don’t see a further rate cut (to -0.5%) or a boost in the asset purchase program for the moment, therefore we don’t think we will see a lot of volatility in the coming days. we wouldn’t take an important position in the Euro, however we can see EURUSD trading above 1.13 by Thursday noon.

Chart 3. EURUSD and Fibonacci retracements (Source: Bloomberg)

Another important factor EU policymakers will have to deal with in the future is lower growth and inflation expectations. The 2017 GDP growth expectation decreased to 1.20% (vs. 1.70% in the beginning of the year) and the 5y/5y forward inflation expectation rate is still far below the 2-percent target (it stands currently at 1.66% according to FRED).

Sterling Pound: New Trend, New Friend? The currency that raised traders’ interest over the past couple of weeks has been the British pound as it was considered oversold according to many market participants. Cable is up 5% since its August low (1.2866) and is approaching its 1.35 resistance. We would try to short some as we think many traders will try to lock in their profit soon which could slow down the Pound appetite in the next few days. If 1.35 doesn’t hold, then it may be interesting to play to break out with a new target at 1.3600.

Chart 4. GBPUSD and its 1.35 resistance (Source: Bloomberg)

We would short some (GBPUSD) with a tight stop loss at 1.3520 and a target at 1.3350. No action expected from the BoE on September 15th, Carney is giving the UK markets some ‘digestion’ time after the recent action (rate cut + QE).

USDCHF: For the Swissie, our analysis stands close to the Yen’s one, and therefore we think the Swiss Franc strength could continue in the coming days. we like 0.96 as a first ‘shy’ target, and we would look at the 0.9550 level if the situation remains similar (poor macro and quiet vol) in the short term.

AUDUSD: Australia, as many other commodity countries (Canada, New Zealand), remains in a difficult situation as the deterioration of the terms of trade will tend to force RBA policymakers to move towards a ZIRP policy. However, lower rates will continue to inflate housing prices, which continue to grow at a two-digit rate. According to CoreLogic, house prices averaged 10-percent growth over the past year, with Sydney and Melbourne up 13% and 13.9%, respectively. Australian citizens are now leverage more than ever; the Household debt-to-GDP increased from 70% in the beginning of the century to 125% in Q4 2015 (see chart below). This is clearly unsustainable over the long-run, which obviously deprives policymakers to lower rates too ‘quickly’ to counter disinflation. As expected, the RBA left its cash rate steady at 1.50% today, which will play in favor of the Aussie in the next couple of weeks. One interesting point as well is that the Aussie didn’t react to an interest rate cut on August 2nd, something that Governor Glenn Stevens will have to study in case policymakers want to weaken the currency. There is still room on the upside for AUDUSD, first level stands at 0.7750.

Chinese Yuan: The Renminbi has been pretty shy over the past two month, USDCNH has been ranging between 6.62 and 6.72. The onshore – offshore spread is now close to zero as you can see it on the chart below (chart on the bottom). We don’t see any volatility rising in the next few weeks, therefore we wouldn’t build a position in that particular currency.

Chart 5. CNY – CNH spread analysis (Source: Bloomberg)

To conclude, we think that we are going to see further dollar weakness ahead of the FOMC September meeting as practitioners will start to [re]consider a rate hike this time, especially if fundamentals keep being poor in the near future.

## Ahead of the ECB and Fed meetings: watch the VIX

In this very quiet week, the SP500 is once again ‘playing’ with the 2,100 level and we strongly believe that it could be a perfect time to go short if you think about the upside / downside risk. There are many events coming up starting with the ECB meeting tomorrow and Non-Farm Payrolls on Friday. We guess we could see some volatility coming from these events which could impact equities and the FX market. As we wrote here, we saw that usually EURUSD tends to be positively correlated to sudden rise in volatility. Even though we expect the ECB to keep its rates steady (deposit at -0.4%, refi at 0% and marginal lending facility at 0.25%) with no increase in the current 80-billion-euro QE program, the market may react negatively during Draghi’s conference starting 1.30pm. Once again, the ECB could disappoint, leading to equities sell-off and some Euro appreciation. As you can see it in the chart below, EURUSD has entered in a bearish trend since May 3rd, decreasing by 5 figures until it hit its 200-SMA (yellow line) at 1.11. It has been trading within a 90-pip range over the past 3 days and we expect the currency pair to stay rangy today as well; however we would pay attention to the potential spike we can see tomorrow. The first strong resistance on the upside stands at 1.1250, a breakout could directly lead us towards the 1.1350 – 1.1400 range.

(Source: Bloomberg)

In addition, US non-farm payrolls could disappoint on Friday (Bloomberg survey at 160K) leading to another round of equity sell-off, sending the US 10-year yield back below 1.8% and pushing the Euro to higher levels. If we look back at the beginning-the-year sell-off in the chart below, the SP500 (candlesticks) fell by more than 200pts, the US 10-year (red line) crashed from 2.3% to 1.66% while the Euro (green line) surged by 7 figures to almost 1.14 against the greenback.

(Source: Bloomberg)

Another reason to go short US equities at the moment could be a good strategy to hedge yourself against a volatility spike ahead of the FOMC meeting (June 14/15). If we look at the FedWatch Tool developed in the CME website, there is a 22.5% implied probability of a rate hike based on the CME 30-day Fed Funds futures prices.

(Source: CME Group)

However, the odds are higher based on the last few speeches delivered by US policymakers and of course a quiet market. In her 30-minute Q&A session with Greg Mankiw at Harvard on Friday, Fed Chairman Yellen said that the economy was continuing to improve and that a ‘rate hike in coming months may be appropriate’. In ouropinion, we think a June move is appropriate, especially if equities still trade above 2,000 until that meeting. In addition, if we look at the Eurodollar futures market, time deposits denominated in US dollars and held at banks outside of the United States, the June contract trades 99.28 (i.e. the implied rates is at 72bps). Eurodollar contracts are useful to look at as well as they are more liquid than Fed Funds futures.

The only reason we see no rate hike this meeting is if we experience another sharp sell off within the next couple of weeks.

## Dollar pause: poor US fundamentals or overall disappointment on more global easing?

Since its high in mid-March last year, the US dollar has ‘stabilized’ vs. overall currencies; if we look at the US Dollar index (Source: Bloomberg, DXY index), it hit a high of 100.40 in March 13th then has been ranging between 92.50 and 100 over the past year. Now the question we have been asking ourselves is‘what is the main reason for this stagnation?’

(Source: Bloomberg)

We strongly believe that one of the main reasons comes from looser-than-expected FOMC statements and a shift in expectations on more monetary policy tightening in the near future. If we look at the market, Fed Funds futures predict a much lower ST rates in the future compare to the Fed’s dot plot. Looking at the chart below, whereas the Fed officials see rates at around 1% and 2% by the end of 2016 and 2017 respectively, the market (Red line) predicts 50bps and 1%. It doesn’t necessarily mean that the market participants are right, but it looks to me that they are more ‘rational’ based on current market conditions and this spread between the Fed and the market may have created a dollar pause over the past year.

(Source: Bloomberg)

The first reason that could explain why the Fed has been holding rates steady since last December would be the poor fundamentals we have seen lately (except for the unemployment rate currently at 4.9%). For instance, US GDP growth rate has been slowing over the past three quarters and came in at 1.4% for the last quarter of 2015 (vs. almost 4% in Q2). If we look at the latest core PCE deflator release (the inflation figure the Fed tracks), the index came in at 1.56% YoY in March, still far below the Fed’s ‘target’ of 2%. In addition, the economic data have been more than disappointing overall, which could explain the recent fly-to-quality and why yields are starting to plunge again (the 10Y YS yield trades currently at 1.8%, while the 30Y is at 2.66%).

Secondly, corporate profits have been plunging and printed a 7.8% fall in Q4 2015, the biggest decline since Q1 2011 (-9.2%) and the fourth decline in the last five quarters. If we look at chart below, we can see that the divergence between the S&P500 index and the 12-month forward earnings doesn’t work for too long and equities tend to be the one moving in general. You can see that in that case, equities are still overvalued based on this analysis and there is more potential downside coming in the future.

(Source: ZeroHedge)

The third and most important reason explaining this status quo – i.e. US dollar pause – would be the current global macro situation. Certainly, market participants have been recently disappointed by the recent news coming either from Japan (no additional QE see article) or the Eurozone and the loss of confidence in the ECB. On March 10th, Draghi announced the ECB Bazooka plan, where the officials decided to:

• cut decrease the deposit refi and marginal lending rates to -0.4%, 0% and 0.25% respectively
• Increase the QE from 60bn to 80bn Euros per month
• Implement a four new target LTROs (TLTROs) each with maturity 4years
• Include investment grade euro-denominated bonds issued by non-bank corporations clong the assets that are eligible for regular purchases

The effect on the market was minor; if we look at the chart below, the Euro increased in value against the greenback (green line) and the equity market stands at the same level since the announcement (Eurostoxx 50 index trading slightly below 3,000).

(Source: Bloomberg)

The sales-side research suggest that CBs should consider purchasing equities as well or taxing wealth (Deutsche Bank) as a intermediate step before implementing the Helicopter money strategy.

Despite a recent spike since the beginning of the year mainly driven by the recovery in oil prices (WTI spot increased from 26\$ to 43\$ per barrel), commodity prices are still trading at their lowest level since 1998 according to the Bloomberg BCOM index (see chart below). China’s (and other EM countries’) slowdown continue to weight on international finance putting a lot of export-driven countries into difficulty (or close to default). We personally believe that this situation will remain in the next 12 to 18 months as the emergence of a credit crisis in the EM market is not too far away.

(Source: Bloomberg)

Therefore, we think the global lack of easing will tend to stabilized the US dollar in the medium term; another rate hike from Yellen in one of the next two meetings is sort of priced in by the market, therefore only action from the rest of the world could start to bring interest into the US dollar. we would be careful of going short equities at the moment as USDJPY is very low and a response from the BoJ (more ETFs purchases) is kind of imminent if Kuroda wants to stop this current equity sell off and Yen purchases.

## Macro 2: Euro update

After the first part on Japan, the second one will give a current status on the Euro Zone economy and the ECB. As in Japan and US, the deflationary cycle has also been a big issue (the annual HICP inflation rate has been moving around 0% over the past year) due to this commodity meltdown.

QE recap: As you know, Mario Draghi announced in January last year that the Central Bank will start expanding its Balance Sheet. The QE programme, called the Public Sector Purchase Programme (PSPP), started on March 9th 2015 and was first planned to last until September 2016. The purchases will be split between sovereign bonds and securities from European institutions and national agencies, and will amount a total of €60bn worth of bonds each month. As you can see it on the chart below, the announcement was quite a success if we look at the stock market; Eurostoxx 50 Index (candles) went up 28% between January 2015 low and April’s high of 3,836. At the same time, the programme also pushed down the single currency (green line) to 1.05 against the greenback, making the dream of certain EU’s officials come true.

(Source: Bloomberg)

However, it didn’t take too long for the situation to change. The 10Y German Bund yield surged from a low of 4.9bps reached on April 17th to a high of 105bps on June 10th, a net change of 1% in simply 6 weeks. At the same time, the equity market went down 500 points and the Euro surged to 1.15, on rumours that the Fed will lose its ‘patience’ and start a tightening cycle and a weak and irreversible EMU. If we look at the moves on the interest rate market (European sovereign bonds and the single currency) since the famous meeting in May 2014, it is clear that the market’s participants had been front running Draghi on the basic rule of the ECB’s Will To Power. However, the two charts (especially the moves on the German Bunds) describe that this situation can change suddenly, drastically and very quickly.

(Bund 10-year, source Bloomberg)

In order to calm those market moves and restore a new bullish and stable trend in the market, the ECB’s answers were quite limited and combined a few promises (ECB ‘unlimited options’ jawboning, what does it really mean?), with a decrease in the deposit facility rate (from -0.2% to -0.3%) and an extension of the PSPP programme by an extra six months (until the end of March 2017). We saw that the market reacted negatively to those news and the EuroStoxx 50 Index trades now more or less at the same level (3,000  points) than in January last year (in order words, QE failure…).

When it comes to the Euro, there are a few things that fascinate me as it usually concerns more participants than its 19-nation economy. First of all, the chart below shows the deposit rate of the following countries’ central bank:

• ECB at -0.3% (Blue/White line)
• Sweden Riksbank at -0.35% (Yellow line)
• Denmark at -0.65% (Red line)
• Swiss SNB at -0.75% (Purple line)
• Norway (Base Rate) at 0.75% (Green Line)

(Source: Bloomberg)

As you can see, all CBs switched to NIRP policies (expect Norway) over the past year to counter this deflationary cycle and sluggish growth; it seems that all other European economies (with Switzerland) have been forced to follow the ECB moves in order to avoid a sharp local currency appreciation (vs. the Euro). Therefore, when you hear about the ECB’s decisions, you must think what will happen to those economies as well (and some Eastern European ones as an extent). We will see what are the consequences and reactions in the near future (12 months) as we know that NIRP policies tend to inflate asset prices ‘artificially’, especially the real estate market (look at Sweden, or Norway for instance), and force banks to pass on the negative carry to their clients (questioning the value of money as it is better to hold money under the mattress than in a negative interest-bearing bank account).

Secondly, the Euro has been reacting positively (and violently) to a few market events, like the August flash crash (EURUSD surged from 1.1365 to 1.1714 in a single trading session on August 24th) or the Draghi’s disappointment on December 3rd (EURUSD went up by 5 figures that day). We are always questioning what can explain that? A first answer could come from the fact that the Euro has become one cheap funding currency, and during periods of stress, the carry unwinds lead to some Euro appreciation. It can explain some strength, but not sure about those drastic moves. Another explanation could be that sometimes, the Euro acts a safe-haven currency. We explained it a couple of articles (here and here), that we have to look at how the market is currently positioned (late correlation with the VIX index).

A quick EURUSD analysis:

At the moment, we visualize the Euro as a ball still full of air that everybody is trying to sink under water. However, everybody’s weight (which can be described as market participants’ view) can change and if it becomes too light, the ball can come up to the surface quite quickly naturally). The EURUSD-pair looks rangy; a strong support stands at 1.07 with a resistance area 1.10 – 1.1050 (100 and 200 SMA) where the bears are waiting to short. One careful thing to watch (and potentially play) is in the upside in case the 1.1050 level is broken; this could trigger many stops and bring the Euro to last year’s highs (1.14 – 1.16).

(Source: Bloomberg)

## A Euro update ahead of the ECB meeting

As we are in the middle of a market turmoil, with equities down 10 to 15 percent since the beginning of the year, we thought that a quick update on the Euro (and where it is going) could do it. With Eurostoxx index down 12% and peripheral sovereign and financial risk spiking (Banca Monte Paschi di Siena down 60%, trading at 51 cents), markets’ participants are questioning themselves ‘what more could the ECB do?’ Currently on a €60bn bond-purchases program (which duration was extended to March 2017) combined with a NIRP policy (deposit rate at -0.3%), there is not much that Draghi could offer to the market in order to depreciate the single currency to lower levels (parity?) and stabilize the market.

Since the Euro’s recovery when Draghi’s credibility was threatened at the December’s meeting (no increase in the asset purchase programme), EURUSD has been trading sideways over the past 6 weeks within a 350-pip range (1.07 – 1.1050). It looks like the single currency is struggling to break trough the 1.10 strong resistance, and We believe that a lot of bears are waiting to go short around that area. However, we would be cautious on a new disappointing news coming from the ECB that could potentially send EURUSD to new highs. Unless the Governing Council reveals a new plan to stabilize the Euro Zone economy and its stagnating inflation rate (+0.2% in December), there are no main reasons why the Euro should decline drastically tomorrow. One chart that we like to watch when volatility spikes is EURUSD and its correlation with the VIX index. As you can see it on the chart below, the 10-day correlation has moved from 0 to 74% over the past two weeks, with the VIX index trading slightly below 30. We think it could be interesting to watch the overnight session and its impact on tomorrow’s trading session, as we know that the single currency can act as a safe haven asset in periods of high volatility (and low liquidity). The last time was on August 24th as we wrote it in our article EURUSD and VIX last September.

(Source: Bloomberg)