The Thumbnail Sketch of the Euro You are Looking For

Here is an overview of the broad macro considerations for the euro, with some thoughts about the price action, including volatility. It is shared not so much as an argument as a sketch the considerations that drive a view.  

1. An 18-month low for the euro was set on April 26 a little above $1.11, immediately after the US reported a stronger than expected Q1 GDP report. The euro has been consolidating here in May and has been unable to rise above the $1.1265 area on two attempts.

2. The eurozone economy appears to have stabilized after slowing in 2018. Surveys have been weaker than hard data. Inflation appears to have bottomed (~1.4%), and the combination of higher oil prices and the weaker euro will help underpin CPI through the summer.  Nevertheless, the plans for a new targeted long-term refinancing operation (TLTRO) are still going forward.  

3. The escalating US-China trade conflict is not good for Europe. Foreign producers in China, servicing the US market may shift out of China, but Europe is unlikely to be a significant beneficiary. Also, the US tariffs could deflect China’s export prowess more toward Europe. One of China’s responses will be to emphasize “self-reliance,” which can be expressed as an import substitution strategy. This undermines the export-driven economies, especially Germany, in Europe.

4. President Trump has threatened a 25% tariff on auto imports and decision is expected before the end of May. Should such a tariff be implemented, the euro would likely sell-off, even though Europe would retaliate.

5. An important low for the euro is probably not in place, and there still seems to to be potential for another leg lower than could take it to the $1.08-$1.10 area. Such potential drivers would include, disappointingly weak growth in Germany, mainstream parties lose a majority in the European Parliament, new political and/or economic challenges from Italy, or US auto tariffs.  After a period of relative calm, Italian politics and the doom loop linking banks and the sovereign remains very much intact, and risks here appear to be mounting and may build further ahead of the EU Parliament elections.  

6. Analysts have been bearish the dollar in general since what is often described as the Fed’s dovish pivot. They have relented only in the very near-term, Bloomberg surveys show median forecasts look for the euro to outperform the forward in H2 19.  Speculators (non-commercials) in the futures market are extremely short the euro.  The net short position is the largest in three years.  The gross short position is near 260k contracts (125k euros per contract).  There have only been five or six periods in which the bears have been willing to amass such a short position over 250 contracts.  

7. The implied euro volatility tends to rise now as the euro falls. Three-month implied volatility recorded a five-year low near 4.80% in the second half of April.  When the euro recorded its low on April 26, vol briefly traded above 6%.  During the consolidative/corrective phase here in May, the implied volatility has eased back to 5.3%. 

8. The two-year interest rate differential has narrowed as the market prices in Fed rate cuts.  It has been trending lower since peaking at more than 350 bp last November. It is now near 280 bp, the lowest since February 2018. The 10-year differential has narrowed by 30 bp to less than 250 bp over the past six months.

9. In the big picture, the dollar’s third big rally since the end of Bretton Woods remains intact. However, in the past, the last phase of the dollar bull cycle took place while interest rate differentials moved against the US. If this holds, this super-cycle that began more than a decade ago is nearly over.

10. The major currencies (OECD) typically do not move much more than 20% +/- its purchasing power parity (PPP) calculation. The euro is now about 23% undervalued. It did reach nearly 30% undervalued in late 2016.