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Euro Rally Is Under Threat As Supportive Factors Wane: Macro Man

(Bloomberg) — This week there seemed to be a default feeling in the marketplace that the time was ripe for a euro correction, and thus far that’s turned out to be the case. While the broad dollar has also fared well, of course, this still looks like a euro move first and foremost. Whether the current pullback lasts another couple of days or morphs into something more serious may ironically depend on technical traders who don’t care about fundamentals or the narrative. Let’s have a look at the factors that got us to 1.20 and where they now stand:

  • Rate differentials: While the move in the Treasury/Bund spread from 2.30% in December to nearly 1.70% in July clearly justified a euro rally, the degree of appreciation seemed to overshoot the move in rate differentials. Recently, the spread has stabilized and if anything looks like it’s trying to break higher. Meanwhile, short rate spreads have moved sharply in the dollar’s favor in recent weeks
  • EU politics. The outcome of the French presidential election exerted a statistically significant influence over the euro in the run up to the vote, and the good feelings engendered by the election of the establishment candidate in France are at least partially responsible for the strength of the single currency since the spring. However, this factor has been neutered by the performance of the AfD in Germany, the ongoing popularity of populists in Italy and Austria, and a somewhat messy situation in Spain
  • U.S. politics. Like him or loathe him, it’s pretty clear what Donald Trump is at this point and the failure to enact meaningful legislation has lost its capacity to surprise or disappoint. While Trump does appear to have had a somewhat negative influence on the dollar this year, for what it’s worth Trump’s poll numbers have improved over the past month or so
  • Positioning. The market was indubitably short in Q1 this year, and a good chunk of the rally was engendered by short-covering and a switch to long positions in some quarters. This looks like the real reason for the euro’s outperformance versus traditional drivers. While it’s difficult to get a firm handle on market-wide positioning, what we can say is that just about everyone who bought euros against the dollar over the last couple of months is offside
  • Other factors. The euro-zone current account surplus is a nice little tailwind that isn’t going away. Then again, it was also there during the euro’s decline so it’s hard to build too bullish a case on it. A more favorable factor is FX reserve managers; as they accrue more reserves, they naturally reallocate a portion of them to euros. Of course, if the dollar really starts ripping, reserve managers will find less need to buy them — and have fewer reserves to diversify
  • “If the euro can hold 1.1660, the outlook remains favorable” is the kind of banal tautology that generally adds little value to anyone. That being said, a CTA model proxy suggests that that level is where the first round of euro stop losses likely reside. If they get triggered, expect some post hoc fitting of the story to the price action. If the narrative proves sufficiently strong, it could propel the euro back to the 1.10-1.12 area suggested by rate differentials
  • NOTE: Cameron Crise is a macro strategist who writes for Bloomberg. The observations made are his own and are not intended as investment advice.

To contact the reporter on this story: Cameron Crise in New York at ccrise6@bloomberg.net

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