EUR short-squeeze might come to an end soon

Outlook:

We wrote yesterday the US has to deliver a steady stream of really good data for the dollar upswing to grow legs, but we are not likely getting it today—service sector PMI, trade, Redbook. Not top-tier market-movers. So that lets us focus on Europe, where we have three items to mull over. First, the EC forecasts. Well, aside from the entirely sensible downgrade of the Greek outlook, they are just forecasts. We are not bothering to report the inflation forecast because it says exactly what wishful thinking says it should say—the bottom is in. We shall see.

As for Greece, it looks like capitulation on privatization and it also looks like Mr. Draghi will not heed his colleagues who want to turn the screws on the Emergency Lending facility. Technically, Draghi controls the situation. Cutting off access to ELA would trigger the default in about ten second. At a guess, Draghi doesn’t want to be the guy who pulls the trigger. If we understand the situation right, the Greeks have yet to capitulate on pensions and labor market reform. The creditors care more about those two things than they do about tax collections and corruption—but Greece is declining to commit. Mean-while, Greece is running out of money.

The IMF’s new stance—that creditors will have to take another hair-cut—is weird. It seems to put the IMF on Greece’s side but that doesn’t seem likely, although it may be true in the sense that the IMF agrees with Greece that the old bailouts were badly designed and obviously unworkable. An acknowledgment of the unsustainability of the bailout plans would probably go a long way toward mollifying Greece, even if it’s not an actual apology. It might even be the IMF’s tactic in the “game” of negotiation—we’ll get you debt reduction in return for pension and labor market reform. Or maybe the party the IMF is negotiating with is exactly what it looks like on the surface—the other European government institutional creditors. Take a haircut or we won’t pay Greece and you’ll lose it all.

Many observers note the absence of contagion to other countries and point out that Greece simply doesn’t matter in the grand scheme of thingsits economy is simply too small. But dismissing Greece as unimportant or irrelevant is to miss the bigger picture of the institutional integrity of the EMU. For the IMF to feel obligated to step in to tell EMU institutions how to behave is actually quite shocking. It might even be considered insulting, as though the EMU is some badly managed emerging market coun-try that needs firm guidance from the grown-ups.

The Europeans may look on the IMF as just a source of some extra money from some taxpayers other than EU taxpayers, but the IMF seems to perceive itself as the captain of the ship. Whatever else this means, it’s not good for the EMU wish to supplant the US and its wish for the euro to supplant the dollar as the top reserve currency. If the eurozone can’t manage even a gnat like tiny Greece, how can it be trusted with the world’s wealth?

The other European story is the sell-off in German Bunds that has taken the yield from 0.0485% on April 17 to the close yesterday at 0.451%. Market News does a review, interviewing global strategists, who note that the rebound has tended to fail at about 0.43% several times since January. If the yield holds that line this time, we could see a run toward the 200-day moving average at about 0.644%. Others say “no way.” Special circumstances are confusing the issues, including Greece and a failed 5-year auction. The basic conditions—zero inflation and the ECB having just begun QE, do not justify a rise in yields that has any lasting power.

Therefore, the euro short-squeeze will come to an end, and probably pretty soon, as the Bund falls back to zero and into negative territory. So, if the Bund action is a temporary correction, so is the euro’s rise. The two viewpoints are not really in opposition. Maybe the Bund yield does go to 0.644%--so what? In the grand scheme of things, it will go to zero eventually. The only thing that might prevent it would be the ECB declaring QE will be reduced or ended, and that is not the way the ECB does business. Once it has declared QE will go on to end-2016, retreating would be a very big deal that nobody can see coming.

So, for the immediate future, the highest we see the euro is 1.1175, maybe 1.1225. Then, if we get a con-tinuation of the downmove, we will be looking for tests of previous lows, perhaps all the way to 1.0996, the 50% retracement. It all depends on how much more short-covering is out there.