As investors rush to short the euro, some analysts are saying the trade has become overcrowded, which could lead to extreme volatility in the euro-dollar pair.
Because the pair is so heavily oversold, even a shred of positive economic data out of Europe, or an unexpected outcome in the political arena, could cause investors to quickly swap their dollars for euros.
”When the market is so one sided and really short a single currency, the slightest positive news could see the euro enjoy outsize appreciation,” said Joe Manimbo, senior market analyst at Western Business Solutions.
Even without a shred of positive evidence, a short-covering rally could emerge if enough large investors decide to cash out of their trades and collect their profits around the same time, said Jonathan Lewis, chief investment officer at Samson Capital Advisors.
The euro EURUSD, -0.13% fell to a nine-year low of $1.18 in early North American trade Monday before recovering to $1.19.
Potential triggers for a euro bounce include a victory for Greece’s pro-bailout New Democracy party, which is led by Greece’s Prime Minister Antonis Samaras, Manimbo said.
“An event like that could show that the market’s biggest fears were a bit displaced or the market’s biggest fears were not realized,” he added.
Any recalibration in the market’s opinion of when the Federal Reserve could begin the process of raising interest rates could also spur a rally in the shared currency. The dollar has risen largely on the expectation that the Federal Reserve is preparing to begin the process of raising interest rates mid-way through 2015. If economic data, or a raft of hawkish statements from Fed officials, cause the market to delay its hike expectations, the euro could rally.
“If that changes, that takes away an important support for a stronger dollar, which could mute the impact of a dollar rally, or mute euro decline,” Lewis said.
The European Central Bank could disappoint investors by not establishing a large government-bond buying program, a regimen that economists refer to as quantitative easing, during the coming months, as the market expects.
Lewis cautioned, however, that such a scenario should not be taken as an indication that economic growth is improving in what has been a sluggish European economy.
Gains for the euro could have far-reaching affects on other asset classes, analyst said. Any sign of a meaningful recovery in the European economy — an event that would likely lift the euro — could also spur a recovery in oil, Manimbo said, as the buying power of European investors and consumers strengthens.
Lewis said a resurgent euro would likely whet investors’ appetite for risk, helping to spur a rally in European stocks.
Any event that would cause the euro to rally would likely also be bullish for European Stocks, Lewis said, adding that it’s difficult to say how a euro rally would affect European sovereign debt.
