FX Update: EURUSD to spike higher still?

John J. Hardy, FX Consultant.

FX Update: EURUSD to spike higher still ?

The Euro squeeze is still definitely on as we start a new week in financial markets. Supporting the nearly across-the-board upside in Euro once again today after an already sharp move higher last Thursday and Friday is the collapse in intra-European sovereign debt spreads and apparently the spike in European yields at the short end of the curve, as reflected in the yields of instruments like German t-bills and Euribor. As well, the higher Euro represents the pain trade for so many macro portfolios out there that have been shorting the currency aggressively all year until the last several weeks, which is probably providing a form of latent supply of Euro buying all the way up.

On Friday, we mentioned the rise at the front end of the European curve possibly being about a removal of the safety premium for holding non-PIGS debt (most importantly, German debt) while noting the relative easing in the type of "counterparty risk" trades that suggest a banking system in crisis. (If we remember back to the US financia crisis, the counterparty risk trade was a key story that developed for months and was only snuffed out starting several weeks after the actual Lehman bankruptcy event after an unprecedented spike.) At the same time we have the easing in Euro sovereign debt spreads, particularly for Spain, where the 2-year spread vs. Germany has collapsed to 128 bps from about 175 bps last Thursday and over 200 bps as recently. This is an enormous move.

All of these factors suggest an easing situation in Europe on the surface: but the most important question here is possibly whether higher yields at the front end of the curve mean an easing fear level or a rising fear as the rate spike represents a scramble for Euro liquidity. The latter explanation actually makes more sense and is one we haven't considered sufficiently as we were distracted by the lack of evident fear in counterparty risk (which was a hallmark of the US credit crisis). That's because the ECB has responded sufficiently strongly to keep counterparty risk off the table (no banks of any size allowed to fail) and has the firepower to backstop the sovereign debt situation for a time as well (especially now that China seems to want to jump in and buy sovereign debt, too - perhaps with the hopes of a stronger Euro as the real agenda. Yet, overall, liquidity remains very tight, especially for speculators with large positions funded in Euro that are beginning to feel the pain, and as everyone scrambles for cash, there aren't enough Euros available. So the question now is how much further we have to go in the squeeze process. In the EUR/pro-risk trades, there may be a very long way to go, especially if we see any follow through on Friday's very ugly move in the risk trades. In EURUSD, it is tougher to estimate - have a look at the chart below.

Chart: EURUSD vs. 2-year swap spreads
If the continued widening in interest rate spreads are supposed to reflect a scramble for Euro liquidity, then we might expect for the EURUSD rally to only end once Of course, at any time, a strong official response by the ECB or very large EUR selling from central banks that are relieved to see EUR back at these levels could slow the rally. Our assessment of the dynamic is this: it can go anywhere in the short term, but the higher it goes, the better the sell opportunity for the long term since this seems to be mostly about a short-term liquidity event rather than the long-run fundamentals, which have been adjusted permanently lower for the EuroZone by this year's crisis. It's one thing for rates to rise because of hawkish expectations for a central bank, another thing entirely when they rise for the liquidity reasons. In any case, an reversal in the widening spreads at the front end of the curve will likely coincide with an end to the EURUSD rally.

HUF and puff, and blow the Franc down
The IMF announced over the weekend that it refused to advance a planned $25 billion dollar payment to Hungary after it noted sufficient progress in Hungary's efforts to right its public finances. This was of course met with a gap lower in the HUF to open the week, but the action in EURCHF also reminds us of the aspect of the Swiss franc that has bothered us all along - the risk of default on Swiss franc loans extended during the bubble years (whereas the market has . Remember that most Hungarian mortgages were financed in CHF in those years... Of course, the EURCHF rally here has been aggravated by the EUR liquidity squeeze as well.

Looking ahead:
After the Friday meltdown, the direction in risk appetite is as important as ever and we're still surprised at the lack of response in volatility fears in the likes of the VIX and FX vols - that's either divergence that should encourage the bulls or a sign of excess complacency....

The other main highlights this week is the presentation of the stress tests for European banks, an event risk that could also provide an inflection point for the Euro rally. Ahead of that, however, we have Bernanke's semi-annual testimony before Congress on Wednesday and Thursday - a critical event for Fed watchers, as it represents the ideal forum for the Fed announcing a move in a new direction.

Other highlights this week include:

Today:

• US July NAHB Housing Market Index - normally a very good leading indicator on the US housing market, though it gave off a very strange spike in May that was erased in June. Would expect a very low reading on this survey today that suggests very slow interest in new home buying in the US.
• Australia RBA Meeting Minutes - key for Aussie rate expectations, which recently crossed below zero for the year ahead before rising a bit again.

Tuesday

• US Jun. Housing Starts and Building Permits - market looking for further double dip confirmation here for housing.
• Bank of Canada Rate Announcement - most expecting another hike, but should we be looking for a further deceleration in the hawkish rhetoric as the BoC nervously eyes the slowdown south of the border and budding signs of weakness in Canada as well? Still over 100 bps priced into the year forward for the BoC.

Wednesday

• UK BoE Minutes - looking for whether the bank is waffling on its dovish inflation view after the latest troubling signs of sticky inflation levels
• US Fed's Bernanke Humphrey Hawkins testimony - there is a gathering storm in the US economic data, and the recent FOMC minutes suggest an increasing feeling by many in the Fed that the recovery is failing. This could be an interesting performance by Bernanke as the market puts out feelers for when and to what degree the Fed is looking to head for QE, Part Two.

Thursday

• EuroZone Jul. Preliminary Manufacturing and Services PMI - amazing how resilient these have been in the face of the crisis - will we finally see more definite signs of slowing?
• Canada May Retail Sales - not a particularly timely report and the data series is very choppy. Still interesting to see this report after a very weak April reading
• US Weekly Initial Jobless Claims - last week looked encouraging, but this is the trickiest time of the year for seasonal adjustments  - this week and next week should be important for establishing whether the claims levels are really improving.
• US Jul. Existing Home Sales - weak number expected

Friday

• Germany Jul. IFO - spectacular that this index has remained so elevated through the crisis - but the DAX is not that far from highs for the cycle either (the two often move hand in hand). The stronger Euro could help this survey register a sizable drop this time around.
• UK Q2 GDP - expected at a relatively strong 0.6% QoQ by consensus, the best since 2007. The last hurrah?
• Canada Jun. CPI - inflation is certainly not the driver for BoC policy.

Economic Data Highlights

• New Zealand Jun. Performance of Services Index out at 55.7 vs. 53.5 expected
• UK Jul. Rightmove House Prices declined -0.6% MoM vs. +0.3% in Jun.
• EuroZone May Current Account out at -5.8B vs. -5.6B in Apr.
• EuroZone May Construction Output fell -1.0% MoM and -6.3% YoY

Upcoming Economic Calendar Highlights

• US Jul. NAHB Housing Market Index (1400)
• Australia Jul. RBA Meeting Minutes (0130)