One thing about tables, they turn. This time last year, the dollar was unrivalled. Now, it is being challenged amid a banking crisis, recessionary fears, and a debt ceiling drama.
Having stepped up on the rates faster than the rest, the US Fed’s combat against inflation fuelled a dollar rally . It now finds itself between a hard place and a rock. Many expect the Fed to pause.
In contrast, the ECB, having been slower off the block, has gradually lifted rates with ample headroom for further policy intervention to fend off a resurgent Euro area inflation.
This paper explores fundamental forces driving a rally in the Euro and the headwinds facing the dollar.
With EUR/USD making a golden cross on March 27th, this case study posits a long position in Euro using the CME Euro FX Futures delivering a 3x reward to risk ratio with entry at 1.1025 and target of 1.17 hedged by a stop at 1.08.
Crushed and Bruised Euro is Fighting Back
2022 was a crushing year for the Euro. Geopolitics plunged Europe into an energy crisis. Bleak prospects plus soaring inflation meant deep recession. The Euro was wounded.
The Euro was dealt another blow as the ECB was slow to lift rates. Key eurozone rates were well below those in the US, as the Fed was all pedal to the metal with unprecedented hikes.
Higher yields in the US attracted foreign funds, boosting the dollar at the expense of other currencies.
Tables turn and times change. Euro's rise is in part thanks to milder European winter. Warmer than normal and prudent energy consumption has kept gas prices in check. The region may well avoid a recession. In fact, it posted a surprise output growth in the final quarter of last year.
A hawkish ECB also well supports the Euro. It continues to hike rates to tackle inflation, which remains stubbornly high.
As rates in Europe rise while those in US stall, the Euro will attract capital inflows from across the Atlantic.
Dollar’s dominance is being challenged
Over the last 10 years, the Dollar Index (DXY) has gained ~25% while the EUR/USD has shed ~19%.
The rotation away from the dollar is underway. Not only Euros, but the dollar has also been losing ground against other majors, including the sterling and the yen.
Easing inflationary pressures should spell victory for the Fed allowing it to tone down its fighting monetary stance.
Premium for insuring against US government default spiked to its highest level in more than a decade amid political impasse related to debt ceiling. While this political embarrassment is likely to be inconsequential, the tiny risk of a dollar debacle cannot be ignored. Investors hedging against this risk are likely to push the dollar lower.
Is this De-dollarisation?
The de-dollarisation camp shouts loud. But ignore the noise.
Surely, the weaponisation of the dollar has alarmed nations. Not surprisingly, many are attempting to wean away from dollar dependence for trade settlement.
The dollar’s share in forex reserves used to be 71.5% at the turn of the century and has gradually declined to 58.3% as of the end of 2022.
The dollar remains at the core of global trade and finance. The dollar forms 88% of FX transactions. Distant second is Euro at 31%, according to 2022 BIS figures (aggregates equal 200% as each transaction involves two currencies).
Transactions involving the Chinese yuan having grown at 70% over last three years represents a mere 7% of the total.
About 60% of the world's forex reserves aggregating to USD 11 trillion are still denominated in dollar.
The dollar will continue to play a pre-eminent role in global trade and as a global reserve for a long time to come. Absent a credible alternative, albeit weakened, the dollar is here to stay.
Rate Expectations Point to the Fed Pausing Earlier Than ECB
CME’s FedWatch tool shows a 78% probability of another 25bps rate hike at the next meeting on May 3rd and a 67% probability of no rate hike at the June meeting. Fed pause before pivot remains market expectations.
Meanwhile, Reuters reported that the ECB is expected to raise rates by 25bps at its next meeting in May. Crucially, ECB survey of professional forecasters points to another 25bps rate hike in Q2 before pausing.
Asset Managers & Funds are positioning for Euro to rally
CFTC’s Commitment of Traders (CoT) report shows that leveraged funds and asset managers are bullish Euro. Asset managers increased net longs by 7.4% over the last 12 weeks. Leveraged funds have flipped from net short to net long, increasing long positioning by 125%.
Meanwhile, the CoT for DXY futures shows that asset managers are still net long but have reduced long positions by 20.5%.
Options Market are signalling bullish Euro and bearish Dollar
Monthly options on Euro FX futures are trading with a put-call ratio of 0.87 pointing to more calls than puts, indicating Euro bullishness. Euro buoyancy is particularly apparent for June expiry options which have a put-call ratio of 0.6.
Meanwhile, thinly traded options on DXY futures expiring in June have a put-call ratio of 1.66 signalling that market participants are bearish dollar with 1.66 puts for every call option.
Trade Setup
Each lot of CME Euro FX Futures provides exposure to 125,000 Euros. Every 0.00005 increment in the contract represents a trading P&L of USD 6.25.
● Entry: 1.1025 ● Target: 1.17 ● Stop: 1.08 ● Profit at target: USD 8,440 ● Loss at stop: USD 2,810 ● Reward-to-risk: 3x
MARKET DATA CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/.
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Comment
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Reuters reported that the IMF called on the ECB to continue with rate hikes until mid-2024 and tighten fiscal policy further in order to control inflation. This would bring EU rates higher than the US and drive the Euro higher.
The US is expected to have expanded in Q1 but at a slower pace than Q4 last year.
The slower growth comes as rates stand at their highest level in 15 years. Higher interest rates crimp lending to businesses and individuals, slowing the economy along the way.
The Fed continues to argue that a “soft landing” of the economy is possible enabling lower inflation without falling into recession. Market participants are less convinced and are pricing in rate cuts by end-2023.
mintdotfinance
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The recovery of the eurozone economy is expected to be confirmed this week with the release of GDP figures showing a return to positive growth in Q1. Natural gas futures are down 45% since end-Dec. Lower energy costs have given a boost to economic activity.
Reuters poll shows that economists expect Q1 GDP to rise 0.2% QoQ and 1.3% YoY. Eurozone industrial production rose 1% MoM in Jan & 1.5% in Feb. Construction also rebounded with growth of 3.8% in Jan & 2.3% in Feb.
Exports were helped by China’s lifting of zero-Covid policies, while imports fell because of lower energy prices. EU trade deficit fell from more than €13bn in December to almost zero in February.
mintdotfinance
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Dollar is the cleanest dirty shirt. On De-Dollarisation, Brad McMillan, CIO for Commonwealth Financial Network, offers the following neat thought experiment to explain how difficult it will be:
Suppose I told you that Amazon would collapse this year and that people would abandon it and flock to other merchants (e.g., Walmart). That argument makes a certain amount of sense, in that Walmart is indeed a valid competitor, is trying very hard and spending a lot of money to take business from Amazon, and has the scale to do so credibly.
But when you think about it, the idea is kind of silly. Personally, I have an Amazon Prime account, I have multiple orders pre-set, I watch Prime video, and so on. It would be a lot of work and a major inconvenience to switch — even if Walmart offered a full range of competitive services. Walmart may do so, but I haven’t even looked, which kind of proves my point. Unless you believe that tens of millions of people are suddenly going to do the work and endure the inconvenience of switching, then the idea that Amazon will suddenly collapse simply isn’t credible.
I think you see where I am going with this. The US dollar is Amazon, and the Chinese yuan is Walmart. Yes, China would like to dethrone the dollar, but it isn’t that simple. As long as the US is the largest open trading economy, as long as everyone in the world wants access to the US economy, and as long as it is a lot of work and a great inconvenience to switch, the position of the dollar as the global reserve currency is secure.
The slower growth comes as rates stand at their highest level in 15 years. Higher interest rates crimp lending to businesses and individuals, slowing the economy along the way.
The Fed continues to argue that a “soft landing” of the economy is possible enabling lower inflation without falling into recession. Market participants are less convinced and are pricing in rate cuts by end-2023.