In this article we’d like to present the arguments for a bearish call on EURUSD in the first half of 2018, that is, 1.12-1.13 by the end of June. The reasons for that range from sentiment (record speculative long positioning) to fundamental aspects (deeply negative cross currency basis swaps) and is a widely contrarian call. We hope that after reading this article, the reader will get at least a larger picture of what’s happening on the global macro front and we’re looking forward to discussing the matter.
In spite of the largely adopted optimism concerning the Eurozone recovery, we doubt that the said optimism will prevail in the EURUSD pair. In fact, evidence points at a potentially bearish trend forming in the pair over the first half of 2018.
First of all, the markets gradually start pricing in the promised 3 rate hikes in 2018 in U.S. This has taken longer than we expected amid intrigues surrounding the new FED chief, hurricanes and disappointing inflationary data. However, with inflationary forces rising and with FED realising that they need more ammunition should a new recession occur, we project at least 0.75% rise in the overnight rate in 2018.
In spite of the recent divergence between 2 year governmental bond differential and EURUSD (figure 14), we believe that the pair will gradually converge to its “fair value” due to fading optimism surrounding rate hikes in the Eurozone in the foreseeable future and accelerating U.S. economy.
More importantly, we expect accelerating inflation to cause tightening (ANFCI rally) and hence a risk-off environment where investors will exit riskier investments like emerging markets (figure 15) or junk bonds (figure 13) and choose to invest in safe assets like U.S. government bonds, causing more demand for USD (figure 16). Rising inflation will also likely mark tightening of the world economy by making financing operations via bond issuance more difficult, hence straining the risk appetite of investors and spur flight to safety. A rising dollar in turn will likely spur a vicious cycle of falling commodities and costlier EM debt, causing even more flight for safety.
Additionally, we have seen recently severe strain in overall liquidity as investors are trying to get hold of dollars which translates into a negative basis swap (figure 17). Even though the basis swap isn’t at the alarming levels of 2008, it demonstrates overall liquidity strain which will likely worsen with rising interest rates in U.S. and possibly with repatriation of profits due to the tax cuts.
Another concern over the EURUSD bullish argument is the extreme long speculative positioning (figure 18). With the boat being full, a slight downward movement will likely cause a liquidation avalanche and thus squeeze a large chunk of market participants.
We therefore project a level of 1.12-1.13 for the EURUSD by June 2018 (figure 19).
Got other arguments for or against the bearish case? Please feel free to comment and let’s discuss.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.