Fundamental Forecast for the Euro: Bearish

The euro saw its sharpest two-day decline since the height of the financial crisis, highlighting a potential sentiment extreme as leveraged positions hit multi-year highs. A disappointing European Central Bank interest rate decision and speculation that Greece could abandon the euro sparked dramatic sell-offs through late week trade. The sudden tumbles emphasize that currency markets are very easily spooked, and the highest volatility expectations since January warn of major moves in the weeks ahead.

Foreseeable event risk is relatively limited in the coming days, but traders should watch for surprises in the ECB’s Monthly Report and German GDP growth figures on Thursday and Friday, respectively. The European Central Bank disappointed euro bulls in expressing a relatively neutral and cautious bias for monetary policy and all but ruled out a June interest rate hike. Overnight Index Swaps now point to a July interest rate increase at the earliest, and 12-month interest rate expectations likewise show a noteworthy downgrade in medium-term yield forecasts. The ECB Monthly Report and German GDP growth numbers could subsequently help clarify uncertain expectations and spark important EUR volatility. Yet the biggest EURUSD moves could come from development in sovereign debt markets and uncertainty surrounding the Greek economy.

Rumors that Greece sought to leave the European Economic and Monetary Union (EMU) sparked a sharp EUR sell-off, and any corroboration could easily force further declines. Markets have speculated that the Greek government may have significant difficulties returning to international debt markets and some sort of debt restructuring seemed increasingly likely. Abandonment of the euro in favor of a new domestic currency would effectively guarantee a default; a Greek currency would likely fall sharply against the euro at inception and make it significantly more expensive to repay EUR-denominated debt. We subsequently see the risk of Greece abandoning the EMU as relatively remote, but that won’t stop markets from speculating and price in increased risk of debt default. Caution is warranted amidst especially uncertain market conditions.

The Euro/US Dollar currency pair remains strongly correlated to the US S&P 500 and other highly leveraged markets, and options markets point to big moves across most financial asset classes in the days ahead. Friday’s Commitment of Traders data showed net EUR Non-Commercial futures positioning at its most net-long since early 2007 and represented a sharp jump from just seven days ago. The sudden deleveraging across financial markets unsurprisingly forced a short-covering rally for the downtrodden US Dollar, and the key question is whether we can see similar financial market turmoil through upcoming trade.

Our proprietary Speculative Sentiment Index showed that trading crowds remained net-short EURUSD from January, 12 until May 5th—good for an 1800 pip rally. A sharper shift towards crowd buying could in fact signal that this is the start of a larger EUR turnaround.

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