I turned on the TV the other night and was shocked to see college bowling being broadcast. When did colleges start forming bowling teams?! More shocking was when one of the commentators referred to the participants as "athletes."
My athletic career ended in high school, but I’m quite confident that nothing athletic occurs under black lights after three pitchers of beer. Well, at least not anything that can be shown on network television.
Saying people who bowl are athletes is like saying people who play paint ball are Navy Seals.
Just as that announcer got carried away, so too have investors who are piling into the long side of the euro because they believe the European Central Bank is ready to taper and begin shifting towards a more hawkish policy.
The eurozone economy has been humming along for the last couple of years, and that remains the case so far in 2017.
Industrial production has accelerated for three straight months, while the manufacturing and service sectors have improved for nine and four straight months respectively.
These individual components of the economy have allowed eurozone GDP to grow between 1.6% and 2.0% for nine consecutive quarters. That’s what you call economic stability. Even Draghi has acknowledged that recent eurozone growth is “increasingly solid” and the downside economic risks have “diminished.”
But investors who are solely focused on the growth story are forgetting that it is just one aspect of the central bank’s policy equation; the other is inflation.
It Takes Two to Tango
Investors have failed to account for what’s happening or, rather, what’s not happening with inflation. Both the CPI and producer prices accelerated rapidly last fall and winter. But since the beginning of the year, both measures of inflation have essentially flatlined. The latest CPI reading was 1.9%, and producer prices rose in April at a 3.9% annual rate. The latter was a deceleration from February’s 4.5% reading. Just last week, the flash PMI for May showed that prices fell for the first time in 15 months.
Draghi isn’t going to change anything just because eurozone growth is on the right track. He also wants to see eurozone inflation consistently running at 2% for months before he’ll even broach the topic of tapering.
The Italian Job
As if the data aren’t enough to prove the ECB is intent on holding its current course, Draghi himself hasn’t been shy about re-iterating the central bank’s desired policy.
Less than a month ago, Draghi said the ECB didn’t feel good about the trajectory of inflation. When asked specifically about tapering, he said there was “no need to discuss sequencing of removing accommodation at present.” Well, there you have it, folks. He didn’t dodge the question and he didn’t give an answer with a lot of gray area open to interpretation.
The first step towards an ECB taper is for Draghi to publicly communicate that a taper is on the table for discussion within the ECB meetings. That public declaration hasn’t happened yet, and the data are indicating that the most likely path is for the ECB to maintain their current course and wait and watch.
Positioned like Sir Mix-a-Lot
Investors have ignored the signals from inflation data and even the words from Draghi’s own mouth. They’ve headed right into a euro positioning that I refer to as “Sir Mix-a-Lot” because these guys are “long, strong and down to get…” ridiculously long the euro.
Just five weeks ago, investors were massively short the euro to the tune of over 200k contracts. Now, after one massive short squeeze, the bears have been sent packing and investors find themselves with the most bullish positioning in three years.
The problem for these investors is not just that the ECB’s policy is bearish, but that the euro’s quantitative factors are also stacked against them.
First, the euro’s 6.1% rally over the last three months is reaching record levels. The last time the euro experienced a rally of more than 6% in a three month stretch of time was 2011. What’s more, the magnitude of this current rally is in the top 15% of all three month time periods going back to 1971. Bottom line: this rally is already stretched by historical levels.
While the euro has been rallying, its average volatility has also been increasing. In fact, the euro’s volatility is 10% higher than where it started the year.
Anytime a financial market’s volatility is increasing, it’s a bearish signal. The fact that volatility is increasing alongside a rally in the euro’s price is a very bearish signal that bulls are completely ignoring.
Investors are also forgetting the euro’s negative relationship to the U.S. dollar and U.S. yields. If you believe, as I do, that U.S. growth will continue to accelerate further and that the Fed will raise rates once or twice more this year, then these relationships are also decidedly bearish factors for the euro.
Despite the recent weakness in the U.S. dollar and U.S. 10-year yields, both markets continue to hold key price levels above $96.40 and 2.162% respectively.
When the current interest differential between the U.S. and everyone else re-exerts its power, the greenback and U.S. yields will once again begin to grind upwards.
Markets with a deeply negative correlation to either of these U.S. markets will get pummeled. This is especially true for markets like the euro that are experiencing “Sir Mix-a-Lot”-type investor behavior at the tail end of a once-every-six-year rally.
Investors believe that a taper announcement could be coming as soon as September. But September may as well be the year 2063 in economic terms because a lot can happen between now and then. Rather than foolishly think I have an edge on what’s going to happen four months from now, I spend my time better understanding developments occurring right now.
And right now, if you are data dependent, process driven and risk conscious, then how you trade the euro is clear. The data say “bearish”, the process says “short” and the risk is to the downside.