Euro Outlook: Vulnerable to an Upside Correction

The net speculative position at the IMM is record short euros. The single currency's five week losing streak against the dollar is the longest in a year and a half and pushed the euro to sixteen month lows earlier today. The euro fell to record lows against the Australian dollar, eleven year lows against the yen and 15 month lows against sterling.

Talk in the market and the IMM data suggests that even as the market extended its short euro positions in recent weeks, it has reduced short sterling positions and extended long Australian dollar and yen positions.

The extreme one sided and one direction of the market is reaching a point that medium term investors may consider resisting the temptation to chase the market and instead look for a upside correction that will provide a better selling opportunity in anticipation of our mid-year euro forecast of $1.20.

The chief euro angst is two fold. First is the roll-over risk. Here we note that the redemptions and coupon payments by the European sovereigns appear to largely cover the anticipated new issuance. The ratio turns more challenging next month. There is keen interest in the Spanish and Italian bond sales, the first of the year, at the end of this week.

Second, is the threat of sovereign downgrades hanging over the market. This past weekend marked the 3 month anniversary since Moody's place Belgium's Aa1 rating on review. Next Monday is the three-month since Moody's began reviewing France's stable outlook. Yet as often is the case, the rating agencies tend lag the market.

Since Moody's, for example placed France's outlook on review, the premium France pays over Germany on 10-year money has widened from around 95 bp to the 143 that prevails today. We note as well that US 10-year yields fell more in the 6 months after S&P cut the US AAA rating than it did in the previous six months, which covered the period of Federal Reserve purchases.

We suspect the euro is also vulnerable to an upside correction because many have not yet appreciated the implications of two developments. The first is the ECB's 3-year repo on December 21. Because the overnight deposits at the ECB have risen to new historic levels, many conclude that the LTRO is a failure.

Far from that, the LTRO, as we argued at the time, reduces the extreme tail risks in Europe. The Italian yield curve has returned to its positive slope from inversion. The Spanish curve has become more positive. Three-month Euribor has softened. Dealers report other easing in funding tensions.

The second development that few seem to fully appreciate is that the scaffolding for fiscal union is indeed being implemented. Important precedent is being set in Belgium. The EC has reviewed its budget and it took the new Belgium government to task, claiming that it would surpass the 3% deficit/GDP target without remedial action. Belgium took froze some spending, pending its own budget review that will be completed next month.

Greater fiscal discipline requires a review of the budget before implementation, surveillance of the implementation process and some penalty for failure to deliver. Europe has begun delivering.

A move above $1.2800-20 would provide the first preliminary evidence that a meaningful upside correction in the euro may be at hand. Initially, technical considerations suggest potential of the correction $1.2950-$1.3050. Depending on how the correction unfolds, there could be scope toward $1.3200.

At the same time, much good news about the US economy appears to have been discounted. The upside data surprises have reached such a magnitude that risk now is that economists over-correct, just in time for the US economy to cool a bit from the 3%+ pace that seems likely for Q4 11.

In addition, as we noted earlier the FOMC meeting, concluding Jan 25, may show that the Fed's base line forecast is for the first hike in the Fed funds rate takes place several quarters after the mid-2013 time frame the Fed previously adopted.

The argument present here is to under score the over-stretched condition of the euro and to warn medium term investors of the risk of the euro bounce. The euro has dropped more than 11% since late October against the dollar and we suspect it has fallen to within almost 1% of what we anticipate to be a near-term bottom (~$1.25). The correction we anticipate should give investors a better selling opportunity and we target the euro to fall toward $1.20 by midyear.