Sell into 1.12 as Any Upside for the Euro is Likely to be short-lived, according to Westpac

We take a round robin of the range of current views about the outlook for the euro.

Shorting the euro – that is selling it to profit from a fall in its value - is now a “high conviction trade” for analysts at Westpac Bank, who argue the currency is broadly over-valued and subject to likely weakening versus the dollar after next week’s FOMC, when the Fed is likely to adopt a more hawkish tone.

The pair is overvalued according to a comparison of U.S and German bond spreads, which is a common rough valuation method used to determine ‘fair value’:

“EUR/USD materially overvalued against 2yr Bund-Tsy spreads, the latter suggesting 1.05/06 is more "reasonable".

Westpac’s analysts expect to ECB to disappoint markets on Thursday and therefore the euro to appreciate in the short-term, however, they don’t see any short-squeeze (a squeeze is a recovery rally in a strongly down-trending market) as lasting – or having “legs”:

“A run at 1.12 is likely if Draghi does not leapfrog expectations, as seems likely. Any squeeze though likely lacks legs, the FOMC a week later likely to sound more hawkish noting that future meetings are live and the risks are balanced. EUR a sell into 1.12.”

Their technical analysis points to the 1.1050 level as key and any break above that as bullish, in the short-term, however, they see these as opportunities to sell ahead of the FOMC.

Analyst Alvin Tan, of Societe Generale, sees the euro's downside as limited due to the ineffectiveness of non-standard monetary policy measures.

Non-standard measures include quantitative easing and negative deposit rates.

Quantitative easing, is the act by which a central bank prints money for the purpose of buying bonds or IOUs from commercial banks, so that it can provide them with more liquidity or cash with which to lend to the wider economy, including businesses and households, to help stimulate trade.

Negative deposit rates, are when central banks, which are like banks for banks, lower their interest rates to below zero so that banks saving or depositing money with them actually have to pay them for the privilege of looking after their money, in an effort to encourage them to withdraw and lend the money instead.

Tan sees a possibility of the euro weakening after the ECB meeting announcement if the new measures are aggressive enough to send markets lower, however, once the impact has worn off he expects a recovery to push the euro higher again:

“Further easing is expected from the ECB this week but it is unlikely to push the EUR/USD exchange rate lower durably. We do not expect EUR/USD to break below the 1.04/1.05 low reached in 2015 over the course of this year, short of a Brexit scenario.”

This could be interpreted as providing traders with a buying opportunity on the ‘dip’ down to 1.05.

Other banks see a case for the euro weakening, such as ING, for example, who expect the euro to fall by 1.5% after the ECB meeting, due to an expected 5bn rise in its monthly bond purchases.

At Citibank they see a heightened risk that the ECB might go overkill with its easing and surprise participants, pushing the euro lower as a consequence.

They argue most investors are shy of shorting the currency due to disappointment at the December meeting, and this is opening an opportunity:

“The ECB’s mantra is to surprise and with positioning now decidedly leaning towards a less dovish ECB (that also explains the inability of USD to rally post the February jobs report Friday), shorting EUR is now seen as the better risk/ reward play tactically.”

Commerzbank are chasing the EUR/USD lower as it has been rejected by the 200 day moving average at 1.1047.

Commerzbank's Axel Rudolph notes:

"Between here and the 1.1087 September low is quite a pivotal area. Ideally it will again provoke failure and as long as this is the case we will continue to target the December and March 2015 lows at 1.0523/1.0457.

"While capped by the 1.1105 September 23 low, EUR/USD will remain directly offered. Above here will neutralise the immediate outlook. We continue to regard the 1.1377 February peak as an interim high."

Continuation of Range Suggests Option's Strategy

One thing the variety of views – both bearish and bullish – share in common, is that they view as highly unlikely a breakout from the current range between 1.05 and 1.16.

This marries nicely with a trading recommendation from SocGen’s Olivier Korber, who suggests using an options technique to trade the expectation that rates will remain within their current range.

In this way only an extreme movement out of the 1.05-1.16 range would lead to a loss, whilst a continuation within the range would result in a profit:

“Mario Draghi could maintain a strong bearish bias and succeed in pushing EUR rates and the exchange rate lower. But he is very unlikely to be bold enough to send the EUR/USD below the 13y low of 1.0450. The short-term downside would be limited to the 1.07 YTD low. On the other side, disappointment to such an extent that the euro would break above the 2015 high of 1.16 is unlikely.”

As such he advocates using:

“Our structure can be seen as a 1m call, spread strikes 1.1050/1.1350, financed by selling a strangle, strikes 1.0450/1.1350, or equivalently as a seagull, strikes 1.0450/1.1050/1.1350, selling two times the highest strike. As such, investors face unlimited risk at the 1m expiry if the EUR/USD trades below its 13y low at 1.0450 or breaks its yearly range above 1.16.

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