Trade Idea: Short EUR/USD (Target 0.90)

Summary

• We have a big picture bearish view on Europe and near-term dynamics are turning bearish euro.
• ECB hawkishness has likely reached a near-term peak, and downside growth risks are under-estimated.
• Carry in favour of the dollar and terms of trade should support a lower euro too.
• We go short EUR/USD targeting 0.90 (stop 1.04).

We’ve been bearish Europe for several months now. There is a clear big picture theme of the German growth model ending, but we’ve been hesitant to put on a short EUR/USD trade until now. Part of this was concern that there was a consensus around euro bearishness and part was on the risk of an ECB pivot to hawkishness. We think both are less relevant today.

Option markets suggest less skew for puts than the summer, which could imply less bearish sentiment toward the euro (Chart 1). Moreover, consensus forecasts appear to have downgraded US growth as much as Euro-area growth (Chart 2). This suggests that market participants are not viewing the Euro-area growth picture as uniquely poor. We think the possibility of energy shortages suggest it is.

Then on the ECB, markets have swung to pricing a more hawkish ECB with euro 2y swaps breaking above the 2% high seen in mid-June (Chart 3). Markets are now giving an almost 90% chance of a 75bps hike this Thursday, so a hawkish surprise is less likely.

As for drivers of EUR/USD, we note that the euro is much weaker than rate spreads suggest. This could be viewed as bullish euro, but we are less sure. Indeed, our take is that size of short-rate spreads (carry) between the US and Euro-area could be exerting downward pressure on the euro. That is, short EUR and long USD could be an attractive FX carry trade. Indeed, in the past, whenever the carry in favour of the US has reached over 250bps, the euro has typically weakened (Chart 4).

Finally, the euro is undervalued according to PPP measures, but the euro has cheapened even more in the past (Chart 5). If we reach the undervaluation seen in the early 2000s, this could imply EUR/USD at closer to 0.90. If we throw into the mix the negative terms of trade shock the Euro-area has faced, then such an under-valuation could even be justified.

Therefore, we add a short EUR/USD trade to our portfolio – we target a move to 0.90 with a stop at 1.04.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)