Battle of the EUR/USD Bulge

It is fashionable at the moment to believe that Europe, and all financial assets associated with that famous old continent, are “hopelessly buggered” (to borrow a technical English engineering term). Greece is a catastrophe, the other PIGS not far behind, the policy response is a feckless mess, the Germans are hopelessly stubborn, and the whole ridiculous Rube Goldberg  configuration of acronyms, summits, and bureaucrats is one headline away from unzipping into uncontrolled monetary and economic chaos.  This at least is the market’s story, with the bearish chorus on Europe reaching jet engine decibel levels.

Exhibit A is the speculative EUR/USD short position from the CFTC commitment of traders report, which every Friday shows a fresh record.  Non commercial euro traders are as bearish as they have ever been, exceeding even the extremes seen in May 2010 when the Greek nightmare firs burst on the scene.  CTAs are clearly on board the Euro doom train, but evidence suggests their real money friends are right there with them.  Exhibit B might be this story, reporting that U.S. money market funds (representing almost $600B in AUM) cut their lending to French banks by a modest 97% over the course of 2011…looks like those guys are out already, I would say.

Cheesehedge is also interested in the real money custodial flow information which is compiled by State Street (most recent data summarized in the table below).  The State Street data suggests real money investors have a 93% percentile long in the dollar, against an 18% percentile long position in the euro.  Real money is very clearly underweight Eurozone risk here, even as recent flow data (the first 3 columns) are beginning to suggest a strong flow of money back into the Eurozone.

So, we’ve got more or less record CTA and real money short positions, while a number of other things are happening which aren’t going according to Europocalypse script.  For all the sturm und drang which accompanied Standard & Poor’s drive by downgrade of Europe on Friday, none of the Eurozone sovereigns are selling off except for Portugal (which is a technical victim of index related selling).  Indeed, Italian and Spanish yields are well off their highs of the year, and seem unaffected by the downgrade drama.

Now consider some other important risk correlates with the Euro downtrade of late 2011:  The EUR/USD basis swap and the EUR/USD option risk reversal.  The EUR/USD risk reversal has had a massive rally in recent weeks, with an an almost 3 vol collapse in the put skew.  The EUR/USD 1Y basis swap is lagging behind, but has also tightened considerably.  In the past, a tightening EUR/USD basis and put skew have been strongly associated with rallies in spot EUR/USD  (i.e., the white line in the graph below tends to follow the red and yellow lines higher).

Given the extreme EUR/USD bearishness out there, Cheesehedge believes the euro is setting up for a fairly imminent, and fairly epic, short squeeze.  Yes, we know Greece is a joke.  But the euro is also Germany’s money and Germany is booming (more on that later).  The Euro, and Europe, has a history of surprising its doubters, and as a long term structural euro bear, Cheesehedge has the scars to prove it.

Cheesehedge is reminded of the original Battle of the Bulge, when the Allies assumed Germany was a beaten, whipped dog on the verge of collapse.  Germany’s enemies were therefore shocked at the massive counterattack the Germans launched through the Ardennes in the winter of 1944/1945, throwing the Allies back and extending the war.  Germany ultimately lost (as it will lose this monetary war), but not before inflicting a severe round of unexpected damage on its adversaries.  The Euro was almost certainly a terrible idea from its inception, and the world would be a better place without it.  Nevertheless, Cheesehedge feels a counterattack lurking in the Ardennes.  Even the magazine cover indicator is flashing a warning:

Is this really the end? Not yet…

About cheesehedge

Cheesehedge is a global fixed income trader and portfolio manager living somewhere in America's great Midwest. When not weighing the relative merits of Chevy versus Ford, or John Deere versus Case, this blog intends to ponder the mysteries of international financial markets, interest rates, currencies, central banks, animal spirtis, minneral spirits, distilled spirits, herds, and herd behavior.
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