Short-EUR Position Plays Require Patience

New dynamics are now entering the fray. Prior to this week, capital markets were beginning to buy into the notion the Bank of England (BoE) would initiate a rate hike as early as the fourth quarter. A day and a couple of reports later, the market is focusing on the need for further stimulus to come from the European Central Bank (ECB) and Bank of Japan (BoJ). Sustainable volatility requires rate divergence and that is not just a tighter monetary policy. The potential for looser monetary conditions in the eurozone has all asset classes on tenterhooks — equities in the red, yields at record lows, gold prices rallying and a currency, contained by option barriers, trying desperately to underperform.

Prior to yesterday, investor positioning suggested (long GBP) that the BoE was to confirm the market’s pricing of a November rate hike, but Governor Mark Carney did not indulge. The BoE quarterly Inflation Report was nowhere near as hawkish as expected, as it merely amended its spare capacity view lower, and trimmed the wage-growth forecast for this year and 2015. Carney’s comments contrasted sharply with the BoE’s earlier hawkish tone. Net result; pricing of the first rate hike was pushed from the fourth quarter to the first quarter, 2015, and sterling slumped to a two-month low as the market turned to focus on the ECB.

Eurozone’s Giant Economies Flounder

Dismal economic growth numbers for both Germany (-0.2%, second quarter) and France (-0.0%) released this morning is sending equity indices deeper into the red, and pushing German 10-year Bund yields to trade below +1%, a new record. This is a sure sign that the market is anticipating further simulative action from the ECB. The weakness of regional economic growth in the second quarter only heightens concerns with the overall growth outlook at a time when a rise in geopolitical tensions is going to have a material effect to downside risks. With Germany, the supposed backbone of Europe, facing increased economic headwinds, it could force the ECB to act faster.

Even a breakdown of France’s gross domestic product (GDP) shows no encouraging signs. A rebound in consumer spending only seems to be correcting the fall in the first quarter, and more importantly, capital investment has fallen again. Structurally, France is in poor shape. Political fragmentation is struggling to implement policies and the market should anticipate any future European Union talks to get tenser. For Germany, the weak GDP report could be attributed to some production being shifted to earlier months; nevertheless any material weakness has “knock-on” consequences throughout the region.

Eurozone data is either on balance or worsening which would suggest that this could be the makings of a more prolonged downturn rather than a dip. A sustainable squeeze in growth in Europe or Asia could very much influence the Federal Reserve’s own timing of initiating higher rates. Expect the market to be paying close attention to Fed Chair Janet Yellen’s speech for hawkish tones at the two-day Jackson Hole Economic Symposium in a few weeks. Dealers and investors need to get a sense of the Fed’s current thought process.

What Will the ECB Do Now?

Collectively, the eurozone’s second-quarter GDP (+0.0% versus -0.2%) and the final July harmonized consumer-price index (+0.4% versus +0.4%) was less negative as wider downside misses were expected. The ECB has been adamant that it needs to look at outcome of the first of the targeted longer-term refinancing operation, or TLTRO, to be delivered next month to gauge whether further easing is required. ECB chief Mario Draghi will maintain that the eurozone’s policymakers do not need to be proactive but to take time and assess the impact of June’s easing package. The market could be looking at the first quarter, 2015 before seeing any action from the ECB. Until then, investors and the market will be focusing on eurozone growth and inflation to see if either worsens.

The Greenback Recovers its Strength

The 18-member single currency (€1.3375) has, so far, come out of this morning’s eurozone data rush somewhat intact. This would suggest that the market was probably positioned for a more downbeat report — the weaker short-EUR positions have been squeezed. Overall, the USD is expected to maintain broad support against the other major currency pairs with the greenback aided by divergence in growth, policy, and yields. Even the dollar’s supportive carry-with-yield differentials is moving in favor of the mighty buck — in other words the USD is converting from a “funding” into an “asset” currency. Thus far, the EUR/USD continues to hold above its 2014 low of €1.333 with dealers noting option barrier defense at €1.3325 and €1.3300. Despite large short-EUR positions leaving the topside vulnerable, the overall view remains bearish for the single unit with range trading still preferred until the option barriers come off. It’s only a matter of time before the year’s EUR outright low will be taken out.

Japanese Economy Shrinks

Overnight data shows that Japan machine orders missed consensus (+8.8% versus +15.9%) resulting in renewed stimulus talks. Earlier this week, Japan was able to shrug off the largely anticipated contraction in its second-quarter GDP, but the reaction to a miss in June machine orders figures and the government’s downgrading of the sector has had more of an effect. It has managed to push USD/JPY higher (¥102.45) with the market starting to believe that a consistent shortfall in leading indicators certainly brings a more proactive BoJ back onto the scene.

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