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Euro to Extend Gains as Yield Spreads Narrow, Shorts Unwind

Euro to Extend Gains as Yield Spreads Narrow, Shorts Unwind

2010-07-10 03:35:00
Ilya Spivak, Sr. Currency Strategist
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The European unit’s correlation to risk appetite has all but dissipated, with yield differentials stepping in as the dominant driver of price action. The transition hit home with the expiry of the ECB’s 12-month repo – a lending facility allowing European banks to secure access to the central bank’s funds for a year – which drained available liquidity and put upward pressure on short-term borrowing costs. Taken against a backdrop of withering US yields as lackluster economic data weighed on rate hike expectations while risk aversion encouraged safety-seeking Treasury demand, this helped to narrow the spread between German and US 2-year bond yields to a meager 9bps from 31bps just a month ago, sending EURUSD higher.

The unwinding of record-high speculative short Euro positions has also proved supportive as profit-taking saw traders pare bets against the single currency having priced in the bad news surrounding the outbreak of the EU debt crisis and seeing no new reasons to keep selling. Indeed, a breakdown of speculative positioning published by the CFTC showed futures traders reduced their short EUR exposure to 95.2K contracts last week, amounting to a hefty 41 percent drop from the late-May high of 162K. Although this brings positioning in line with its year-to-date average, traders remain overwhelmingly skewed to the short side by historical standards, suggesting ample room remains for further readjustment.

On balance, a deeper upward correction is likely ahead before the long-term Euro downtrend resumes. The week ahead is relatively light on European economic data, with July’s ZEW investor confidence survey and the final revision of EZ CPI lining up as the only significant items on the docket. Domestically, the main event will be the release of results from a series of stress tests of European banks designed to gauge their ability to withstand a sovereign default in the region. These will determine if the ECB will renew long-term repo operations (LTROs), and outcome that would again deepen the liquidity pool and weigh yields, sending the Euro lower. However, they are not due to be published until July 22, leaving the fundamental landscape largely static in the near term.

Meanwhile, the start of the US corporate earnings season and a wealth of top-tier economic data including retail sales and CPI should take the spotlight this week. US fundamentals have taken a notable turn for the worse in recent months, with more of the same expected in the near term, while companies are likely to trim their profit forecasts amid expectations of a worldwide slowdown in the pace of recovery. Taken together, this should prove to weigh further still on US yields and help encourage continued rebalancing of portfolios way from an overtly short-EUR bias, helping the single currency to add to recent gains.

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