EURUSD: I was wrong, but I will be right

'The last 3/4 months have been pretty average for me, Tim,' I said this morning on our morning chat.

We tend to talk for about an hour or so practically every day at 8am (9am for Tim over in Spain).

'You know, it's difficult to be inspired when there's nothing to really inspire you - getting an opinion across when your optimal framework for doing business is not best represented by the market is a tough one.'

It's true.

The last 3/4 months have been tough for me.

Made some good money selling the euro, gave 40% back and jobbed about here and there, but nothing to say that my usual way of working has fit the current market context.

I was wrong on selling the euro for the reasons I thought and at the time I thought.

And I think perhaps I was a little stubborn.

And I am absolutely fine with that.

See, I find there are different ways to act when you're right and also when you're wrong.

What I note is that I am right for a few months of the year...

And specifically in USD bull markets.

And when I am wrong, I recognise that it's not an optimal period and size down, but still try to stay in the market since I don't know when things will change.

But...

I reckon there are a few points to note about when we'll be right again, and Tim set a lightbulb off in my head about this with the euro...

See partly, I think there's been a forced reason to stay away from the traditional Macrodesiac framework of trying to operate in the tails.

The Corona Virus has dominated the macro landscape, and then we had the election, with little else really mattering in between.

That's not a great environment for me.

However, light appears to be here.

With the marginal cost of lockdowns decreasing with the vaccine coming to deployment, I reckon the virus' impact will gradually start subsiding, and that old theme of central bank policy will firmly recalibrate participants' thoughts on the market.

I'll re-iterate my thoughts on there being a currency war too - use this as the baseline for the rest of this research.

What was the lightbulb that Tim set off?

'Yeah, just looking back at this year, the dollar started selling off after the Fed had offered their swap lines, didn't it?'

Yes, Tim.

It did.

That was the lightbulb.

Take a look at the last three months of USD swap line use.

It has ever so slightly been edging up.

What can we take from this?

Well, it's been noted that in Q3, GSIB (Global systematically important bank) scores had been creeping higher.

This means that they have to hold more regulatory capital.

With the further pressure here from the equity market rally being unaccounted for, it is likely that banks are now forecasting that they will have to try to counteract this rise.

Naturally then, this leads to a bit of a funding squeeze.

This was noted by Mark in the Discord yesterday...

Now, what is interesting about what is happening is that most of the USD liquidity swap usage is occurring through the Swiss National Bank.

Over the past week or so, $5.7bn has been borrowed at the 3 month tenor.

The reason for going through the SNB is that there is no haircut for many securities, whereas the ECB or BoJ does have one (4% and 1.4% on a 10 year treasury, respectively).

Now, what Mark is referring to above is likely the following...

For banks to lower their GSIB scores, they will have to offload some of their equity positions.

They can do this by lending out their equities through Total Return Equity swaps.

This implies though that to make this transaction, the investors who want to participate will have to have USD.

Banks have been scaling back on USD lending more recently, which has spiked the 1-month premia relative to the 3 month.

The potential movement on the 3 month was highlighted in the tweet below by Stephen Spratt at Bloomberg.

Another factor is that if investors do not own the bonds to front for collateral to take up the swap lines, they have to borrow them.

One month borrowing costs for bunds and OATs have surged hitting seriously negative rates.

This process would naturally hit the repo market, and it has been.

The buyer of the bond repo - which is the investor lending the cash to access the securities - is paying interest.

At the same time, Euribor is hitting lows as well - that's the unsecured rate at which European banks borrow from each other.

What does the lightbulb light up then?

Well, I do think there will be some kind of downside faced on XXXUSD pairs into year end based off of funding issues.

I'd even go as far to say that it would be the bottom for the dollar in Q1...

But there is still some upside left in the euro yet from my perspective, perhaps until 1.25.

That's not the trade though; I'm focusing on the downside where there is more risk to reward, and following the longer term trend.

EURUSD specifically, I reckon that we see the real move occur later into the first quarter.

There's a few broad reasons for this, alongside the dollar regaining strength.

I've mentioned before that the introduction of a vaccine would lead to the marginal cost of lockdowns decreasing.

Alongside this, it can therefore be assumed that employment support programmes and business support programmes being removed have a similar effect - the marginal cost of removal decreases slightly.

But I'd say in reality, that is not correct.

What could be said then, is that it is likely that there is a sudden complacency surrounding the economy once vaccinations are fully underway, and with Europe being an extremely hard hit area with pre-pandemic issues as well, they could be a serious victim in this.

Also of note in this context is the probable initial belief that the Recovery Fund will do much.

My thinking is that it won't.

Rather than talk about the Recovery Fund's lack of effects, I think it's more pertinent to refer to the greater risks to European stability, which the fund cannot rectify.

At the moment, there's a hell of a lot of chatter surrounding the non-performing loans in the Eurozone.

I wrote about this a month or two ago.

The FT released an article on December 3rd following on from Mr Enria's (President of the ECB's supervisory board) comments that appeared in the piece above.

For me, this is another theme that is rearing its head.

This doesn't necessarily imply a total banking crisis, but it certainly poses problems for ECB policy makers, and I guess this is where TLRTO comes in.

Isabel Schabel gave an interview on November 30th with regards to TLTROs and PEPP.

Here is an excerpt but you can read our take in the ECB prep piece from earlier this week.

Perhaps then, these TLTROs will continue to work, although like most policy these days, it seems more like can kicking.

As usual, my concerns surround the composition of banking regulations.

Give this a read from Per Kurowski on bank risk weights.

I fear that this is still a massive issue that the ECB can certainly contend with, but only for a limited amount of time - we're talking years, not months here though, but it will be an issue that weighs on the bloc until some kind of reform or lack of confidence comes around.

Basically, the regulations are dogshit and combined with the European Banking Authority's decision to allow banks to weigh domestic sovereign debt at 0, implies that this asset carries zero risk...

When just a few years ago, there was literally a sovereign debt crisis in the Eurozone.

Mental.

So we're putting the pieces together here.

Recall that in 2009, it took about three months for QE to take effect.

If we expect the ECB's December bazooka today to take that long to feed through, might we expect that yields push lower through Q1?

And what effect would this have on the Euro?

Take a look at the below chart.

There is currently a big divergence between the 10 year bund yield and the euro.

My thinking is that we see a range appear on EURUSD through Q1.

As mentioned earlier, dollar shorts are at a net extreme positioning.

See below.

If we consider any kind of funding issue coming to the fore, that could be the catalyst for a bottom.

With that said, it would likely take a while for the trend to change drastically as investors, asset managers and other participants recalibrate.

What could determine the longer term trend change?

We must take note of the dollar smile... yes, again.

Recently, it's been more of a dollar smirk.

Here's a great descriptor from Monex.

See, I think what we can factor in here in the dollar smirk to allow the gradient of the right hand side of the chart to steepen is to consider the dovish response from the ECB, rather than focus on the dovishness of the Fed.

Since the ECB are an 'earlier actor' and in my view, the Fed are likely to keep their stance relatively unchanged, especially with US 10 year breakeven inflation above the pre-pandemic level, we could see some strengthening of USD going forward.

Note the 10 year breakeven below.

Again. we can potentially rely on that 3-5 month time lag for the response to take hold adequately in the FX market.

Compare now to the Eurozone inflation data.

For the last quarter, they have faced deflation - the ECB policy hasn't worked.

In my view, considering the rhetoric from Lagarde and previously Draghi, the desire from the fiscal side of the equation is to boost inflation.

Not going to happen.

As described previously in the European Banks piece above, the factors supressing inflation come from the ECB policy itself, even if they wish for it to be doing the reverse.

I don't think the euro rally is over yet - if it were, it would have been talked down by now.

But I would argue that 1.24-1.27 is the cap on the upside.

Let's watch the price action going forward and see whether all of the above come to light.