This is Goldmans view on the Euro – if someone can understand it can they please tell the rest of us –
1. Risk Correlations: In recent days we had become more preoccupied with potential risks to our tactical trading recommendations. We published a daily on the persistent Dollar correlations with risk assets and on the skew in Dollar risk reversals. Then Themos Fiotakis did a fairly detailed attribution exercise of how far EUR/$ could drop in case of adverse moves in other asset classes. The remarkable drop in commodities over the last couple of days, in particular the drop on Thursday, combined with a sizable move in European rates, was pretty close to the worst-case scenarios discussed internally. European sovereign rumours made it the perfect storm. We have now given back more than half of the potential gains on the long EUR/$ and long EUR/TRY ideas. With some Dollar strength across Asia, our short $/PHP and $/MYR recommendations also have given back part of their earlier gains.
2. How much more EUR/$ Downside Using various forms of attribution analysis in the form of our FX Betas or our Correlation Cruncher, the initial sharp move in EUR/$ looks about fair compared to the moves in other assets. Relative to some of these benchmarks, EUR/$ had possibly overshot by about 1 big figure before the correction. Thursday’s move in European rates added about 1 big figure to the downside and the drop in oil prices was good for another big figure. That brings us from about 1.4850 to about 1.4550. With renewed European sovereign concerns, another 2 big figures are now gone. The risk is that equities sell off in addition to this. Noah Weisberger discussed a temporary move to SPX 1275 in this week’s Tradewinds if the index repriced towards its normal relationship with cyclicals. This would knock another 2 big figures off the EUR/$, but there is a possibility that this that would be partly offset by a simultaneous rally in US rates. Still, one can imagine a scenario where EUR/$ corrects further towards the low 1.40s.
3. Underlying fundamentals remain Dollar bearish: Despite this correction, however, our underlying views have not changed. We continue to expect the monetary policy differential to widen in favour of the Eurozone. Our view that the ECB will hike in July has not changed. We continue to believe the Fed will remain on hold through 2012, with risks to growth and inflation broadly offsetting each other. Global growth may slow a bit but the underlying story remains supportive for equities, where we continue to expect substantial additional upside over the next 12 months (SPX target of 1525). And most importantly after the sharp drop in oil prices, we remain structurally bullish on key commodities, and this despite the fact that Jeff Currie and team had correctly signalled speculative length as an important short-term downside risk. Most importantly, we think the Dollar continues to be on a downward trend, linked to the continued weak balance of payment situation and increasingly the growing fiscal concerns in the US.
4. Our tactical stance after the sharp moves: On the basis of all these factors, we conclude that the Dollar move is only a temporary correction – painful but quite normal in a strong fundamentally driven trend. Moreover, we have made clear from the outset that our current tactical trades have a bit more of a fundamental flavour than normal. For example, the 1.35 stop and 1.50 target on our EUR/$ trade were both quite far from our 1.4085 entry level. Similarly, in our NJA trades we also remain very far from the stops.
5. Asian inflation remains a problem: Despite all the focus on the commodity and Dollar moves, the sell-off in many NJA crosses is unlikely to be in the interest of regional policymakers. Slightly overlooked, the central bank in Malaysia surprised the consensus (but not our Mark Tan) and hiked rates on Thursday morning. The Philippines central banks also hiked rates this week as inflation numbers have come in higher than expected. In this context, sudden local currency weakness is unlikely to help regional policymakers control inflation pressures. And after months of strong intervention to prevent currencies from appreciating, it would only be logical to now act on the other side. In addition, the upcoming US-China talks next week suggest the CNY is unlikely to notably weaken versus the USD.
6. $/Yen below 80 again: Though it was only a short blip, $/JPY briefly dropped below 80 again this week, consistent with a rally in US fixed income. Recent expectations of a slightly more hawkish tone from the Fed had been disappointed. And with falling commodity prices, as well as rising risk aversion, the downside pressure on US interest rates continues to boost the JPY. The Yen is gradually getting closer to the G7 intervention zone again. Overall, we continue to stick to our post-earthquake view that $/JPY will remain in a large and very choppy range.
7. Continued Unwinding Pressure in the CHF: Another dynamic that does not seem to change is EUR/CHF. Every couple of weeks, EUR/CHF moves above 1.30, only to drop sharply below this key level on the next bout of risk aversion. Long-dated implied volatility remains very high, likely still reflecting continued unwinding pressures from legacy carry trades and structured products funded out of the CHF. We described the dynamic in several Global Market Dailies in the past and continue to think it is too early to fade CHF strength.