FX:EURUSD   Euro / U.S. Dollar
The Gross underpricing of ECB and FOMC Monetary Policy Changes - A fully-priced medium-term equilibrium Lower coming?


*Short EURUSD             3m-12m Duration: 1/2lots @1.11 - 1.07TP1; 1.04-5TP2 1.01TP3

1. On Decemeber 2nd the ECB cut their rate by 10bps to 0.05%, paradoxically this actually caused EURUSD             to rally higher. Thus this is a mispricing as Reductions in CB             interest rates send currencies lower as 1) it reduces the demand for the currency as hot money flows, seeking higher rates, falls and; 2) Increases the Supply of the currency as at lower interest rates, banks borrow more and lend more, which in turn (through the bank/ credit multiplier) increases the EUR money supply.

- So reduced demand + increased supply = EUR should have a lower value, so EURUSD             should have fallen. Instead EURUSD             actually rallied 350pips higher to 1.095 on the day - so this policy action has been underpriced

- Though it should be noted that the reason EURUSD             didnt fall was because going into the Dec ECB meeting expectations of Draghi were priced at 15-20bps of cuts so since he "failed" the market reacted hawkishly/ buy EUR.

2. On Dec 16th the FOMC increased their rate by 25bps to 0.50%. For the same, but opposite, reasons above this leads to increased USD demand and reduced supply.

- so the net impact should be aggressively increased USD strength, however, EURUSD             only fell by some 100pips before days after erasing these gains to 1.08 back to 1.10 - so this policy action has been underpriced.

3. On March 10th ECB cut their rate to 0.00% or 5bps and extended their QE programme by several EUR100bn. This once again reduces EUR demand and increases EUR supply (even more so as QE is combined).

- So the net impact once again should be for EUR weakness to be priced in and EURUSD             to trade much lower. However, once again paradoxically on the day EURUSD             actually traded HIGHER? from 1.10 to 1.12 - so this ECB policy action is the third CB             action to go UNPRICED in EURUSD

4. On the 24th of June the UK voted to leave the European Union in a shock Brexit vote - now given that it was a shock vote, EUR should have traded aggressively lower as one of its strongest countries voting to leave its economic union 1) weakens the E.Unions GDP/ Employment/ Inflation status as the UK leaves; 2) Causes uncertainty regarding the new trade agreements between the UK and itself, especially given that the UK is one of the regions biggest export markets; 3) causes uncertainty regarding other nations leaving - a run on the EU could develop.. currently several more nations have called for a vote.

- So all in all the Brexit result is negative for the economic stability of the Euro             area and as a result this should reduce demand for EUR as investors fear the worst/ choose safer currencies. Reduced EUR demand should cause EURUSD             to trade lower - it took a 200pip loss to 1.118 - 200pips of downside is not enough to price perhaps the most uncertain event possible for the EUR (800pips more suitable given UK is 16% of the eurozone).
Comment: *Trading evaluation - Short EURUSD @ 1.11 1.07TP1; 1.04-5TP2; 1.01TP3:*

1. Since Dec 1st where EUR$ traded at 1.06, ECB has cut 15bps + QE EUR100bns+ and the FOMC has hiked 25bps, EUR$ has also undergone the Brexit decision - All of this bearish information "priced" in on July 14th 2016 we trade at 1.1100 - 500pips HIGHER than the Pre-negative stimulus, this is STRONGLY paradoxical, and HIGHLY likely to readjust/ reprice EUR$ lower in the future as the market at somepoint has to account for these fundamental drivers that have ALL gone mis/un-priced - thus a strongly bearish outlook on EURUSD.

2. Secondly, when we look to future fundamental drivers e.g. future ECB/ FOMC decision and other economic possibilities (e.g. more exits/ a turbulent British exit) - the future outlook, regardless of the previous non-pricings, is also strongly bearish EURUSD for a number of reasons:

- 1) As most know the FOMC has begun its hike cycle and every month that goes by comes closer to hiking again, with many FOMC members (see attached posts) being more and more hawkish - future hike expectations/ hikes, increase USD demand/ strength, having a bearish medium-term impact on EUR$.

- 2) The ECB's outlook has turned increasingly dovish, especially in their last minutes, where for the first time in a while the ECB hinted that further easing/ rate cuts are on the cards stating "ECB is ready to act and prepared to use all policy tools available" which was their headline dovish statement - further cuts/easing expectations or realisation puts downside pressure on EUR demand and inc supply, which in turn also contributes to a bearish EUR$ view going forward.

- 3) The Brexit, creates large uncertainty regarding 1) potential new exits, which would have a massive negative impact on the EUR and; 2) even the UK trade/ split negotiations themselves are likely to cause alot of downside volatility in the future as the UK makes up 16% of the areas GDP and is top 5 export market - more exits and the UK negs all contribute to downside pressure on the EUR, which in turn is the 3rd driver for a bearish EUR$ medium run view.
Comment: *Reasons for the Underpricings:*

1. EUR has the largest money supply in the world, 25% larger than the US (GDP weighted). Such a large money supply may cause investors to view EUR as a safe haven as 1) Large money supplies yield stability e.g. no entity can move the direction of the currency easily - an economy with 1bn money supply would be easily moved by speculators trading 100m for example. 2) EUR is the largest export/ import centre in the world so there is large physical demand for EUR; 3) and as mentioned in "1)", the EUR money supply is so large that investor money flows aren't enough to move the currencies relative value, the EUR market is so big that investor flows are unable to move it - this would explain also why EUR has the lowest implied/ realised volatility of any pair, usually around 6-10%, where other currencies trade at 10-20%.

2. EUR is considered a safe have asset, 2016 safe havens have performed 20% higher on average, so this risk-off outperformance would explain how the EUR is able to stop the bleeding DESPITE massive central bank pressure - the JPY's appreciation is a great example of this also; where CB BOJ seemingly has no control on the JPY value, the safe haven market decides its direction (the market is bigger than the central bank?).
Completely agree with this. EURUSD should be trading at parity by now.
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